...Modigliani and Miller proposition one (Modigliani & Miller 1958) assume that the composition of the firm's capital Structure is unimportant on the market value of all firms' securities, and consequently the firm's performance and shareholders' value. “The market value of any firm is independent of its capital structure and is given by capitalizing its expected return at the rate appropriate to its class. “This model depends on two keys, arbitrage and homemade alternative (borrowing on personal account). Arbitrage is the process that ensures that two firms differing on laying their capital structure must have the same performance. At the same time the homemade alternative describes that an investor holding an equity stake in a levered firm can sell his stake, raise a personal loan equal to the share that he held in the levered firm, spend the proceeds in a firm that is not levered and increase his income without additional cost. They assume that the shares of the firms within a given class both have the same expected return and the same probability distribution of expected return, and therefore can be considered perfect substitutes for each other. Modigliani and Miller proposition two This proposition is derived from the first one and it concerns he performance of a Common stock in companies whose capital structure contains some debt. The expected rate of return of a stock of any company belonging to a class is a linear function of the firm's leverage. “The expected...
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...of firms. Major Schools of thought: At the heart of the dividend policy theories discussion are two opposing schools of thought: One side holds that whether firms pay dividends or not is irrelevant in determining the stock price and hence the market value of the firm and ultimately its weighted cost of capital. In retrospect, the opposing side holds that firms which pay periodic dividends eventually tend to have higher stock prices, market values and cheaper WACCs. The existence of these two opposing sides has spawned vast amounts of empirical and theoretical research. Scholars on both sides of the divide appear relentless on showcasing the case for their arguments. Several decades since interest in the area was sparked off by Modigliani and Miller (1961), no general consensus has emerged and scholars can often disagree even on the same empirical evidence! The arguments about dividend policy theory are so discordant in modern day research, that at least there is consensus with Black (1976)’s famous words who defined dividend policy as a puzzle: “the harder we...
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...-------------------------------------- The impact of capital structure on profitability of listed construction companies on Hanoi Stock Exchange from 2008 to 2013 FALL 2014 Instructor Mr. Tran Viet Dung Group members Nguyen Thi Thanh Tam (FB00464) Nguyen Thi Viet Chinh (FB00405) Hoang My Linh (FB00073) Dang Thi Hong Hanh (FB00253) Nguyen Thi Kieu Trang (FB00078) Hanoi, December 2014 Table of Contents List of tables 3 List of figure 4 Abstract 5 Chapter 1: Introduction and Thesis Outline 6 1. Background 6 2. Research objective 8 3. Research question 8 4. Data and methodology 8 4.1 Data 8 4.2 Methodology 9 5. Thesis outline 9 Chapter 2: Literature Review and theoretical models 10 1. Theorem review 10 1.1. Modigliani- Miller theorem review 10 1.2. Agency theory 12 1.3. Trade-off theory 14 1.4 Pecking Order Theory 19 1.5 Market-timing theory 20 2. Variable review 22 2.1. Return on Asset and Return on Equity 22 2.2. Capital structure 23 3. Empirical studies 24 3.1. Relationship between capital structure and firm performance 24 3.2. Empirical studies of relationship between determinants of capital structure and profitability 28 4. Summary of the empirical studies 30 Chapter 3: Methodology 31 1. Introduction 31 2. Data collection methods 32 2.1. Sampling techniques 32 2.2. Data collection procedure 34 3. Variables and hypotheses 34 3.1. Dependent variables 34 3.2. Independent variables 35 3.3. Control...
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...Questions: I. DEFINITIONS HOMEMADE LEVERAGE a 1. The use of personal borrowing to change the overall amount of financial leverage to which an individual is exposed is called: a. homemade leverage. b. dividend recapture. c. the weighted average cost of capital. d. private debt placement. e. personal offset. Difficulty level: Easy MM PROPOSITION I b 2. The proposition that the value of the firm is independent of its capital structure is called: a. the capital asset pricing model. b. MM Proposition I. c. MM Proposition II. d. the law of one price. e. the efficient markets hypothesis. Difficulty level: Easy MM PROPOSITION II c 3. The proposition that the cost of equity is a positive linear function of capital structure is called: a. the capital asset pricing model. b. MM Proposition I. c. MM Proposition II. d. the law of one price. e. the efficient markets hypothesis. Difficulty level: Medium INTEREST TAX SHIELD a 4. The tax savings of the firm derived from the deductibility of interest expense is called the: a. interest tax shield. b. depreciable basis. c. financing umbrella. d. current yield. e. tax-loss carryforward savings. Difficulty level: Easy 15-1 UNLEVERED COST OF CAPITAL b 5. The unlevered cost of capital is: a. the cost of capital for a firm with no equity in its capital structure. b. the cost of capital for a firm with no debt in its capital structure. c. the interest tax shield times pretax net income. d. the cost of...
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...Case #33 California Pizza Kitchen Synopsis and Objectives This case examines the question of financial leverage at California Pizza Kitchen (CPK) in July 2007. With a highly profitable business and an aversion to debt, CPK management is considering a debt-financed stock buyback program. The case is intended to provide an introduction to the Modigliani-Miller capital structure irrelevance propositions and the concept of debt tax shields. With the background of a pizza company, the case provides an engaging context to discuss the “pizza graphs” that are commonly used in corporate finance curriculum to illustrate the wealth effects of capital structure decisions. Objectives: * Introduce the Modigliani-Miller intuition of capital structure irrelevance; * Establish how the cost of equity is affected by capital structure decisions by defining financial risk and introducing the levered-beta capital asset pricing model (CAPM) equation; * Discuss interest tax deductibility and the valuation tax shields; * Explore the importance of debt capacity in a growing business. Suggested Questions 1. In what ways can Susan Collyns facilitate the success of CPK? 2. Using the scenarios in case Exhibit 9, what role does leverage play in affecting the return on equity (ROE) for CPK? What about the cost of capital? In assessing the effect of leverage on the cost of capital, you may assume that a firm’s CAPM beta can be modeled in the following manner:...
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...Persistence and Cross-Section Of Corporate Capital Structure in Indonesia Angelia A. Ananda Clinton M. Yosua Fahressi Fahalmesta Fariz Muhamad Nanda R. Aditya Rio Nugroho Oktober 2013 1. Angelia.ananda@student.ssb.ac.id 2. Clinton.josua@student.ssb.ac.id 3. Fahressi.fahalmesta@student.ssb.ac.id 4. Fariz.muhamad@student.ssb.ac.id 5. Nanda.aditya@student.ssb.ac.id 6. Rio.nugroho@student.ssb.ac.id Abstract Introduction Capital Structure is a factor which essentially needed by a corporate. It is about how a firm finances the overall operations and growth using its combination source of fund. DER (Debt to Equity Ratio) is most likely ratio when talks about capital structure because it related to firm’s leverage. The interpretation of the relationship is when a firm increase the debt and holding the equity constant, DER will goes up. It will be followed by increase in levered value and attractiveness of the firm even though become riskier. Otherwise, there also another beneficial reason of using debt to do the operation and activity of the firm which is the presence of tax shield. Firm will be more profitable because the income will be taxed lower unless; in one condition tax could be zero. Moreover, there was a big question about “How do firms choose their capital structures?” Proportion of capital structure should be made based on calculation and analysis of a company needs. When the measurement is not critical or without good analysis...
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...Capital Structure – Chapt. 16 in text Does Capital Structure affect firm value? MM Proposition I (No Taxes): The value of a levered firm is equal to the value of an unlevered firm. VL = VU. i.e., Financing Choices do not add value. Why? Because you can create homemade leverage if you wish. • Unlevered Firm vs. a Levered Firm with the same assets. Recapitalization of Trans Am Corporation. Debt issue of $4,000,000 at 10% to buy back equity. Alternatively, you may view them as two companies that differ only in their capital structure. Current Proposed Assets $8,000,000 8,000,000 Debt 0 4,000,000 Equity 8,000,000 4,000,000 Shares Outstanding 400,000 200,000 Share price $20 $20 Trans Am Corporation - without debt Recession Expected Boom Earnings: 400,000 1,200,000 2,000,000 Interest: 0 0 0 Earnings after interest: 400,000 1,200,000 2,000,000 Return on equity (ROE): 5% 15% 25% EPS: $1.00 $3.00 $5.00 Trans Am Corporation - with debt Recession Expected Boom Earnings: 400,000 1,200,000 2,000,000 Interest: 400,000 400,000 400,000 Earnings after interest: 0 800,000 1,600,000 Return on equity (ROE): 0% 20% 40% EPS: $0 $4.00 $8.00 Payoffs with Levered Firm and Homemade Leverage Recession Expected Boom Buy 100 shares of Levered Equity at Cost of $2,000 EPS $0 $4.00 $8.00 Earnings...
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...MARRIOTT Case Analysis 1. Are the four components of Marriott’s financial strategy consistent with its growth objective? Manage rather than own hotel assets – Although this strategy has a risk of contract expiration it makes easier to expand. Invest in projects that increase shareholder value – This component definitely stimulates growth, although may force management to take more risk. Optimize the use of debt in the capital structure – The concept of optimal capital structure stands for the growth, nevertheless the techniques used by management sometimes limit it in favour for the higher rating. Repurchase undervalued shares – In a number of cases this component may lead to directing the cash flows not in the projects with positive NPV, which may impede growth. 2. How does Marriott use its estimate of its cost of capital? Does this make sense? Marriott used (or considered to use) the estimate for the cost of capital in two ways: a) Discounted CFs from projects by the appropriate division’s hurdle rate to get NPV, which makes a lot of sense since the risk among divisions varies. b) Thought about incorporating hurdle rate in compensation policy – this doesn’t make much sense, because the rate reflects the risk of activities, not the performance of managers. 3. Compute the WACC of Marriott Corporation: a. What risk-free rate and the risk premium did you use to calculate the cost of equity? To be consistent with risk premium calculations I used the arithmetic...
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...Session 1 Pg 441 2. A=1200 B=1900 Total = 3100 E(Rp)=Wta x E (RA) + Wtb x E(Rb) = 0.39 x 11 + 0.61 x 16 = 14.05% WTA=1200/3100 = 0.31 Wtb= 1- 0.39 = 0.61 E(Ra)=11% E(Rb)= 16% 7. E(Ra) = Pr x E(Rr)+ Pn x E(Rn)+ Pb x E(Rn) = 0.1 x 6%+ 0.6x 7 +0.3 X11 = 8.1% Variance = Pr x [Rr-E(Ra)] ² + Pnx [Rn – E(Ra)] ² +Pb x [Rb-E(Ra)] ² =0.1 x (6 – 8.1)² +0.6(7-81) ² + 0.3 x (11-8.1) ² = 3.69% = square root of 3.69 = 1.92% 11. βp =Wtq x βa + WtR x Br + Wtq X B…. = 0.25 x 0.6 +0.2 x .7 +0.15 x 1.15 + 0.4 x 1.34 = 1.2 14. = Session 1 eg 5.8 Slide 34 βL_ind=0.38 βu _ ind = βL_IND/[1+(1-T) x (D/Eind) 0.38/[1+(1-0.28)x 0.76] =0.2456 Βdyn_Lev = βu_ind x [1+ (1-T) x D/Edyn] = 0.25 x [ 1 + (1+0.29) x 0.82] = 0.39 Chapter 13 question 15 (pg 442) β = 1.3 E (Rm) = 14% Rf = 5% E(r) = Rf + β x [E(Rm)-Rf] – EMRP formula = 5 + 1.3 (14 - 5) 5 + 1.3 x9 16/7% Session 3 Cost of capital Question 3 pg 472 E (R) = Rf + βE(EMRP) = 4% + 1.15 x 8 = 13.2% Slide 6 applies Re = E1/Po + g = D0(1+g)/P0 +g = 1.8(1+0.05)/34 + 0.05 = 10.56% Rc_ave = 13.2+10.56/2 = 11.88% Question 6 pg 472 WACC (cost of funds the company uses to expand – equity and debt)= 13.2 + 10.56/2 = 11.88% WACC = [E/E+D ]x KE +[ D/D+E] x KD x (1-T) TTM = 12 yrs 105% of Face value (nominal, principal) 100 1million R100 ytm is your market rate when issued but after that you have to calculate it. YTM at issue is just the MK (Market) + IR (interest rate) it is the...
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...1. Calculation of WACC of a Multi-Division Corporation 2. Sources of Data and their limitation 3. Use of CAPM, Cost of Equity, Effect of Leverage on the Ce, WACC 4. Use of data for comparable to estimate asset betas for division-specific cost of capital 5. Biases and Limitations No financial modeling. In the previous years they would include WACC as part of case study 3 – Now it has been changed to 2 – without any actual financial statements. No excel modeling. Focused on how to address the issues. Multi-Divisional Comapnies Discount Rate, based on the U.S. The company has three divisions. The profit making divisions, marketing… blah, blah. Very different with each other in terms of how to make the products. Growth, maturity. This issue will become more apparent. For WACC, looking at the formula for WACC, Percentage of debt over the value, cost of debt * Tax Rate, + Equity Value. (1-T) Interest payment to debt holders reflects the benefit of the tax shields, lowering your cost of debt. Capital Structure in general, debt and equity together. Cost of debt… tends to be of a lower percentage as it represents the risk to debt holders thus a lower & compared to risk to equity holders. Why is debt lower than equity? Contractual obligations – Debt Obligations Risk comes into play when the company is at default. Equity shareholders are of a nature of “Residual claim” = they get whatever that is left after all the debt holders have been paid. When the company...
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...DEAN FOODS I- Measuring Riskfree Rate Companies in the USA: Treasury Bill Rate analysis and government bond rate for long term analysis Rj=Rf+βRm-Rf β=0.91 Rf=10 year US Treasury rate the risk free rate=0.039 Rm= 0.028 1. Rj=0.039+0.910.028-0.039=0.02899 or 28.99 % II- Risk Regression A. How well or badly did your stock do, relative to the market, during the period of the regression? Intercept-Riskfree Raten1-β=Jensen'sAlpha Dean Food: Monthly: -0.004-0.00325601-0.91=-0.00401 Annually: -0.004-0.039601-0.91=-0.004059 B. What proportion of the risk in your stock is attributable to the market? What proportion is firm-specific? R2 of Regression=0.6745 or 67,45% suggests that 67,45% of the risk in Dean Food comes from market sources and that the balance of 32.55% come from firm-specific components Firm-specific=1-0.6745=0.3255 C. Annualize the required return on your stock. Riskless Rate+β×Risk Premium Rj=0.039+0.915%=0.0845 Or 8.45% III- Estimating a Bottom up Beta Bottom-up unlevered beta=Current beta1+1-tax rateAverage debtEquity Tax US = 35 % Beta = 0.91 Deb/Equity = 0.53 Bottom-up unlevered Beta = 0.911+1-35%0.53 = 1.04 IV- Estimating a Cost of Debt An interest coverage ratio EBITInterest Expense=13,734,0003,058,000,000 = 4.49 A synthetic rating for Dean Foods 4.25 < 4.49 < 5 therefore rating is A C.A pre-tax cost of debt for your firm Dean Food’s...
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...From investopedia.com Modigliani and Miller's Tradeoff Theory of Leverage The tradeoff theory assumes that there are benefits to leverage within a capital structure up until the optimal capital structure is reached. The theory recognizes the tax benefit from interest payments - that is, because interest paid on debt is tax deductible, issuing bonds effectively reduces a company's tax liability. Paying dividends on equity, however, does not. Thought of another way, the actual rate of interest companies pay on the bonds they issue is less than the nominal rate of interest because of the tax savings. Studies suggest, however, that most companies have less leverage than this theory would suggest is optimal. (Learn more about corporate tax liability in How Big Corporations Avoid Big Tax Bills and Highest Corporate Tax Bills By Sector.) In comparing the two theories, the main difference between them is the potential benefit from debt in a capital structure, which comes from the tax benefit of the interest payments. Since the MM capital-structure irrelevance theory assumes no taxes, this benefit is not recognized, unlike the tradeoff theory of leverage, where taxes, and thus the tax benefit of interest payments, are recognized. In summary, the MM I theory without corporate taxes says that a firm's relative proportions of debt and equity don't matter; MM I with corporate taxes says that the firm with the greater proportion of debt is more valuable because of the interest tax...
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...Lecture 13: Capital Structure Theory Exercises Question 1 Levered Inc. and Unlevered Inc. are identical in every respect except for capital structure. Both companies expect to earn $150 million in perpetuity, and both distribute all of their earnings as dividends. Levered’s perpetual debt has a market value of $300 million and the required return on its debt is 7%. Levered’s stock sells for $100 per share, and there are 5 million shares outstanding. Unlevered has 8 million shares outstanding worth $90 each. Unlevered has no debt. These firms operate in the Modigliani-Miller world with no taxes. How can you take advantage of this scenario? Question 2 Consider the problem of estimating the cost of equity for Crab Inc., a non-listed chain of restaurants specializing in crab meals. Crab has a debt-to-equity ratio of 2 and pays an interest rate of 5% on its debt. Crab’s operations are highly similar to those of the publicly traded Lobster Inc. and Shrimp Inc., which specialize in lobster meals and shrimp meals, respectively. Assume that none of these companies pays taxes. The risk free rate is 2% and the expected return on the market is 10%. Lobster has a debt-to equity ratio of 1, an equity beta of 2, and a cost of debt of 3.6%. Shrimp has a debt-to-equity ratio of 1.5, an equity beta of 3, and a cost of debt of 4.4%. a. Are the debts of Crab, Lobster, and Shrimp risk free? What does this imply for their debt betas? b. Estimate Crab’s cost of equity. Be careful to do it using...
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...Analysis Terminal Values However, the valuation calculated above is based on the projected cash flows over the period of five years operations, but since AirThread is a going concern business which means that business operation of AirThread would continue even after the five years, probably till infinity. Meanwhile, the cash flow projection for the future results after five year operation would be more prone to wrong estimations of the revenues and expenses, in addition to this, the future is uncertain and it would be too difficult to calculate the future results of a business because the business is expected to continue for an unlimited future time. Therefore, in order to account for the future cash flows of a going concern business after the projected results we need to calculate a value that would reflect the value of business operation till infinity and to do this a reasonable growth is used to for the estimation of cash flows till infinity, thus, the value of these cash flows till infinity is known as the terminal values. Weighted Average Cost of Capital and Discounting of Terminal Values However, the weighted average cost of capital represents the overall cost of financing the company’s operations and this value represents the returns required by the equity holders and the returns required by the debt holders. In case of AirThread, the cost of equity would be calculated using the average returns offered by the market for an equity share with similar characteristics...
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...primary factors that influence capital structure decisions. Distinguish between a firm’s business risk and its financial risk. Explain how operating leverage contributes to a firm’s business risk and conduct a breakeven analysis, complete with a breakeven chart. Define financial leverage and explain its effect expected EPS, and the risk borne by stockholders. on expected ROE, • • • • • Briefly explain what is meant by a firm’s optimal capital structure. Specify the effect of financial leverage on beta using the Hamada equation, and transform this equation to calculate a firm’s unlevered beta, bU. Illustrate through a graph the premiums for financial risk and business risk at different debt levels. List the assumptions under which Modigliani and Miller proved that a firm’s value is unaffected by its capital structure, then explain trade-off theory, signaling theory, and the effect of taxes and bankruptcy costs on capital structure. List a number of factors or practical considerations firms generally consider when making capital structure decisions. Briefly explain the extent that capital structure varies across industries, individual firms in each industry, and different countries. • • • • Learning Objectives: 13 - 1 LECTURE SUGGESTIONS This chapter is rather long, but it is also modular, hence sections can be omitted without loss of continuity. Therefore, if you are experiencing a time crunch, you could skip selected sections. Assuming you are going to cover the...
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