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Corporate Finance

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Corporate Finance ­FIN 622
VU
Lesson 20
CAPITAL STRUCTURE AND FINANCIAL LEVERAGE
In this hand out we shall cover the following topics:
When to use WACC?
Pure Play
Capital Structure and Financial Leverage
WHEN TO USE WACC:
As we have covered in our lecture that using WACC as discount rate for discounting the cash flow of
intended project, is only feasible if the proposed project fall within the firms existing activities circle. For
example if a Oil manufacturing concern plans to establish another production facility then the existing
WACC of the firm can be used as discount rate. However, if the same firm is thinking to set up a new
spinning unit, then using existing WACC would be fatal and inappropriate.
WACC of a company reflects the level of risk and WACC is only appropriate discount rate if the intended
investment is replica of company's existing activities ­ having same level of risk.
Using WACC as discount rate when the intended project has different risk level as of company then it will
lead to incorrect rejections and/or incorrect acceptance.
For example, a company having two strategic units and one unit having lower risk than the other, using
WACC to allocate resource will end up putting lower funds to high risk and larger funds to low risk
division.
The other side of this issue emerges from the situation when a firm is having more than one line of
business. For example a firm has two divisions: one of these has relatively low risk and the other has high
risk.
In this case, the firm's overall WACC would be the sum of two different costs of capital, which is one for
each business division. If two of these are contenders for the resources, the riskier division would tend to
have greater returns so it would be having the major chunk. The other one might have huge profit potential
ends up with insufficient resources allocated.
Pure Play
Using WACC blindly can lead to severe problems for a firm. Because we cannot observe the returns of
these investment, there generally is no direct way of coming up with the beta. The approach must be to find
a project or another firm in the industry in which our proposed project falls. We can use the beta of that
firm along with the D/E ration prevalent in that industry.
Once we have the beta and D/E of the firm or industry that resembles to our project we can estimate the
exact beta and D/E of proposed project. For example, if the industry (in which our intended project will
fall) has a beta of 1.7 and D/E ratio of 40:60, and we intend to finance the new project through equity only,
we can calculate the exact beta of intended project which, in turn will be used to calculate the new project
WACC or discount rate to evaluate the project cash flow. This process may involve un-gearing and re-
gearing.
Gbeta x (E / E + D(1-t))
Formula to un-gear equity Beta
=
Gbeta = Geared beta (1.7 in our example)
E
= Weight of equity in capital structure
D
= Weight of debt in capital structure
T
= Tax rate
In this example we need to un-gear the beta. Why? Note that the beta of the industry in which the proposed
project falls has D/E ratio of 40:60 but the new project shall be all equity financed. We un-gear the beta ­
that means the financial risk element needs to be removed from the geared beta of 1.7.
If we plug in values in the above equation we get the value of un-geared beta of 1.3296, which is also
WACC as there is no debt. This should be used as discount rate to evaluate future cash flow of proposed
project.
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Corporate Finance ­FIN 622
VU
Pure play refers to what has been described above. We need to gauge the systematic risk of the new project
in order to calculate the beta and WACC to be used for discounting cash flow.
Capital Structure & Financial Leverage:
FOR the most part, a firm may choose any capital structure. Capital structure refers to the combination of
financing through equity and loans or debt. If management might decided to issue new shares and pay off
bond debt in order to reduce the debt-equity ratio. Activities like this are known as capital restructuring.
This is in fact a change of investment source leaving the firm's assets unchanged.
In the last 4/5 lectures we discussed the concept of WACC. It is simply the firm's overall cost of capital and
comprised of weighted average of the costs of various components of firm's capital structure. Now the
question arises that what happens to cost of capital when we change the relative weights of debt or equity?
The value of firm is maximized when WACC is at its lowest level. As you know that WACC is the discount
rate appropriate to evaluate the cash flow, the lower the discount rate the higher the present value of cash
flow. In other words, present value and discount rate move in opposite direction, lower WACC will ensure
maximizing the cash flow of the firm.
Thus, a firm must choose the capital structure so that the WACC is minimized. A capital structure that
minimizes the WACC would be better than the other one which with higher WACC.
Financial Leverage
The amount of debt in capital structure of a firm is known as financial leverage. In other words, how a firm
utilizes the amount of debt. The more debt in capital structure, there is greater financial leverage.
Financial leverage magnifies the payoffs to shareholders. It means that it increases the profit and loss with
more percentage than a percentage change in sales. It may be possible that financial leverage does not affect
the cost of capital. It is true then firm capital structure becomes irrelevant.
For example, a firm is all equity financed. Total assets are Rs. 6.0 million which are finance by 200,000
shares of Rs. 20 each. It is assumed that EBIT (Earning before Interest & Tax) is Rs. 800,000 in first year
and Rs. 1.20 million in second year. In this case, EPS (Earning per share) will be Rs. 2.67 & Rs.4 per share
respectively in first and second year. The ROE (Return on Equity) is 13.33% and 20% respectively for year
1 & 2.
Now consider that the firm decides to employ debt in it capital structure. The asset side will remain
constant at Rs. 6.0 million. In the proposed restructuring the D/E ratio of 1 is applied. It means that Rs. 3
million will be invested from equity and Rs. 3 million of debt is employed. Interest rate is assumed at 10%.
Assuming the same level of EBIT in both years, the EPS is now Rs. 3.33 and Rs.6 and ROE has jumped to
16.67% and 30% in first and second year respectively.
This magic is played by the financial leverage. It has increased both EPS AND ROE after debt was mixed
up in the capital structure.
Y
DEBT
EPS
NO DEBT
BE
+ FIN LEVERAGE
2
X
300000
600,000
EBIT
-2
-IVE FIN LEVERAGE
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Corporate Finance ­FIN 622
VU
Financial leverage can also increase the losses as well. Looking at the graph above, if the EBIT is not
enough then it magnifies the losses. At EBIT of Rs. 600,000 the EPS is Rs. 2/-. If the EBIT is less than
point BE it represents the negative impact of debt. If the EBIT is falling right to the BE point it increase
the return, the positive financial leverage.
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Table of Contents:
  1. INTRODUCTION TO SUBJECT
  2. COMPARISON OF FINANCIAL STATEMENTS
  3. TIME VALUE OF MONEY
  4. Discounted Cash Flow, Effective Annual Interest Bond Valuation - introduction
  5. Features of Bond, Coupon Interest, Face value, Coupon rate, Duration or maturity date
  6. TERM STRUCTURE OF INTEREST RATES
  7. COMMON STOCK VALUATION
  8. Capital Budgeting Definition and Process
  9. METHODS OF PROJECT EVALUATIONS, Net present value, Weighted Average Cost of Capital
  10. METHODS OF PROJECT EVALUATIONS 2
  11. METHODS OF PROJECT EVALUATIONS 3
  12. ADVANCE EVALUATION METHODS: Sensitivity analysis, Profitability analysis, Break even accounting, Break even - economic
  13. Economic Break Even, Operating Leverage, Capital Rationing, Hard & Soft Rationing, Single & Multi Period Rationing
  14. Single period, Multi-period capital rationing, Linear programming
  15. Risk and Uncertainty, Measuring risk, Variability of return–Historical Return, Variance of return, Standard Deviation
  16. Portfolio and Diversification, Portfolio and Variance, Risk–Systematic & Unsystematic, Beta – Measure of systematic risk, Aggressive & defensive stocks
  17. Security Market Line, Capital Asset Pricing Model – CAPM Calculating Over, Under valued stocks
  18. Cost of Capital & Capital Structure, Components of Capital, Cost of Equity, Estimating g or growth rate, Dividend growth model, Cost of Debt, Bonds, Cost of Preferred Stocks
  19. Venture Capital, Cost of Debt & Bond, Weighted average cost of debt, Tax and cost of debt, Cost of Loans & Leases, Overall cost of capital – WACC, WACC & Capital Budgeting
  20. When to use WACC, Pure Play, Capital Structure and Financial Leverage
  21. Home made leverage, Modigliani & Miller Model, How WACC remains constant, Business & Financial Risk, M & M model with taxes
  22. Problems associated with high gearing, Bankruptcy costs, Optimal capital structure, Dividend policy
  23. Dividend and value of firm, Dividend relevance, Residual dividend policy, Financial planning process and control
  24. Budgeting process, Purpose, functions of budgets, Cash budgets–Preparation & interpretation
  25. Cash flow statement Direct method Indirect method, Working capital management, Cash and operating cycle
  26. Working capital management, Risk, Profitability and Liquidity - Working capital policies, Conservative, Aggressive, Moderate
  27. Classification of working capital, Current Assets Financing – Hedging approach, Short term Vs long term financing
  28. Overtrading – Indications & remedies, Cash management, Motives for Cash holding, Cash flow problems and remedies, Investing surplus cash
  29. Miller-Orr Model of cash management, Inventory management, Inventory costs, Economic order quantity, Reorder level, Discounts and EOQ
  30. Inventory cost – Stock out cost, Economic Order Point, Just in time (JIT), Debtors Management, Credit Control Policy
  31. Cash discounts, Cost of discount, Shortening average collection period, Credit instrument, Analyzing credit policy, Revenue effect, Cost effect, Cost of debt o Probability of default
  32. Effects of discounts–Not effecting volume, Extension of credit, Factoring, Management of creditors, Mergers & Acquisitions
  33. Synergies, Types of mergers, Why mergers fail, Merger process, Acquisition consideration
  34. Acquisition Consideration, Valuation of shares
  35. Assets Based Share Valuations, Hybrid Valuation methods, Procedure for public, private takeover
  36. Corporate Restructuring, Divestment, Purpose of divestment, Buyouts, Types of buyouts, Financial distress
  37. Sources of financial distress, Effects of financial distress, Reorganization
  38. Currency Risks, Transaction exposure, Translation exposure, Economic exposure
  39. Future payment situation – hedging, Currency futures – features, CF – future payment in FCY
  40. CF–future receipt in FCY, Forward contract vs. currency futures, Interest rate risk, Hedging against interest rate, Forward rate agreements, Decision rule
  41. Interest rate future, Prices in futures, Hedging–short term interest rate (STIR), Scenario–Borrowing in ST and risk of rising interest, Scenario–deposit and risk of lowering interest rates on deposits, Options and Swaps, Features of opti
  42. FOREIGN EXCHANGE MARKET’S OPTIONS
  43. Calculating financial benefit–Interest rate Option, Interest rate caps and floor, Swaps, Interest rate swaps, Currency swaps
  44. Exchange rate determination, Purchasing power parity theory, PPP model, International fisher effect, Exchange rate system, Fixed, Floating
  45. FOREIGN INVESTMENT: Motives, International operations, Export, Branch, Subsidiary, Joint venture, Licensing agreements, Political risk