Finance-WK 4

Cost of capital definition from company and investor POV

• From an investor pov: the required rate of return from the project or company they’re investing in in order to be accepted

• From company pov: the cost of the debt and equity the company uses

do you use the market or book value for finding the proportion of debt and equity

market value

kd formula

risk free rate (Rf) + default spread

Te (effective tax rate formula)

te = tc(1-ʎ)

ʎ= is 0 in a pure classical system

ʎ= 1 in pure imputation system

λ = the proportion of corporate tax claimed by shareholders

the higher λ is, the less attractive debt comes, because you get less tax savings from debt

What does beta represent

It represents how the stock moves with the market portfolio’s returns. sensitivity of stock to movements in the return of market portfolio. it is the systematic risk of the asset.

what happens to kd as the debt ratio increases

kd starts to go up, because the default risk increases leading to a wider default spread.

what happens to ke as leverage increases

• it also increases because ke consists of business risk risk and financial risk and financial risk increases as leverage increases.

• levered beta considers the D/E ratio

why does WACC go down till a certain point as you increase debt

because debt is cheaper than equity and because of the interest rate tax shield this makes debt even cheaper causing kd and the wacc to decrease. this is until financial risk starts to increase

• More weight (D/(D+E)) on cheaper kd; so, CoC is decreasing

issues with WACC

• using company wide WACC for a company with multiple subsidiaries or divisions may bias the projects the company accepts

What does the MM theorem assume

that the value of a firm is independent of a firm’s financing decisions.

• it assumes no taxes

• no transaction or bankruptcy costs

• no asymmetric information

• no agency costs

• market efficiency

• perfect competition

Trade off theory

states that the optimal capital structure of a business comes from balancing the tax shield of debt with the expected costs of financial distress

• provides a range of optimal capital structure

• debt increases the firm value by reducing the tax burden since interest payments are tax deductible

VL=Vu+Te x Debt-PV(expected distress costs)

Expected costs of distress formula

probability of distress x costs of financial distress

probability of distress: is industry risky, is firm strat risky, macroeconomic conditions

costs of distress

• Direct costs

  • legal costs, advisory costs, court costs

• Indirect costs

  • opportunity cost (management putting more effort into dealing with debtholders instead of helping run company)

  • the effects of damaged reputation on scaring away customers and suppliers

debtholders bear realised costs, shareholders bear expected costs

Implications of trade off theory

• firms should issue equity when leverage is too high and the stock market should react neutrally to this

• what actually happens: companies are reluctant to issue equity cuz stock price drops when firm does this

pecking order assumption

• assumes management knows more

• assumes market reads into signals

• assumes management is reluctant to issue equity cuz of negative market reaction

• assumes that issuing debt leads to more rigidity from covenants so assumes firms prefer internal equity

therefore order: internal equity>debt> hybrids>equity

Other factors affecting capital structure

• types of asset firm owns

  • if a firm has general assets, they are easier to sell upon bankruptcy compared to specific assets so firm is able to take on more debt

  • tangible over intangible assets might make firms more inclined to be able to take on more debt

• FCF firm has

  • might take on more debt to reduce managers wasting this excess money

• Firm characteristics

  • young R&D firms have lower leverage cuz they’re prob of distress is high and they have more intangible assets

  • low growth, mature, cpaital-intensive firms have high leverage cuz stable cash flows contribute to low prob of distress and have tangible assets so lower costs of financial distress.

what companies actually consider most important when deciding capital structure/taking on debt

1. financial flexibility (which debt restricts)

2. voltaility of cash flows

3. credit rating (cuz this affects cost of debt)

4. transaction costs of issuing debt

5. tax advantage of debt

what does the estimation of beta depend upon

• the time period you use (ie. past 5 years)

• the interval u use

• the market index that you use as a proxy