1 Finance School of Management FINANCE Review of Questions and Problems Part V: Chapter 16 & 17

2 Finance School of Management Chapter 16: Capital Structure  Main Contents: Some concepts: – Internal financing/ external financing – Equity financing/ debt financing The irrelevance of capital structure (M & M) – Tax and costs of financial distress – Conflicts of interest: agency costs  managers-shareholders: free cash flows  shareholders-creditors: overinvestment Evaluation of levered investments – APV (the adjusted present value) – FTE (the flows to equity) – WACC (the weighted average cost capital)

3 Finance School of Management M&M ’ s Frictionless Environment u No income taxes u No transactions costs of issuing debt or equity securities u Investors can borrow on the same terms as the firm u The various stakeholders of the firm are able to costlessly resolve any conflicts of interest among themselves In this frictionless environment, the total market value of the firm is independent of its capital structure

4 Finance School of Management u Corporate income taxes and subsidies Taxes CF Somedett = Net Earnings + Interest =.66(EBIT – Interest) + Interest =.66EBIT +.34Interest = CF Nodett +.34Interest Market Value of Somdett = Market Value of Nodett + PV of Interest Tax Shield  Somdett's market value is maximized by having as much debt as possible

5 Finance School of Management u As the proportion of debt in a firm's capital structure increases, so too does the likelihood that firm might default on its debt u Firms that are in imminent danger of defaulting on their debt obligations are said to be in financial distress u Cost of financial distress – the time and effort of the firm’s managers – fees paid to lawyers specializing in bankruptcy proceedings – lost business because of the threat of bankruptcy Financial Costs

6 Finance School of Management Trade-off Between Taxes and Financial Distress Low Tax Shields Dominate High Financial Distress & Bankruptcy Dominate Optimum Maximum ● Debt Ratio Stock Price or Firm Value Effect of the Debt Ratio on Stock Price

7 Finance School of Management u When managers have a lot of discretion about how to allocate a firm's cash flows, there is a temptation to use the cash to invest in projects that – do not increase the wealth of shareholders (NPV<0) – increase the power, prestige, or perks of the managers u Debt financing will lessen the conflicts by reducing the amount of free cash flow available to managers because the payments of interest and principle to debtholders are prescheduled Managers-Shareholders Incentive Problems: Free Cash Flow

8 Finance School of Management u Because of limited liability of shareholders, managers acting in the best interests of shareholders have incentive to undertake more volatile investments that have the effect of increasing the wealth of shareholders at the expense of the debtholders Shareholders-Creditors Incentive Problems: Overinvestment

9 Finance School of Management u Suppose the firm’s current assets are worth $100 million, and the firm has debt with a face value of $ 104 million maturing a year from now. Consider the investment alternatives: – Investing in riskless T-bills maturing in one year pay an interest rate of 4% – Investing in a venture that will either be worth $ 200 million or nothing a year from now (be choosed) Overinvestment: An Illustration Moral hazard problem: managers might have an incentive to redeploy the firm’s assets in a way that actually reduces the firm’s total value in order to increase the equity value.

10 Finance School of Management u In chapter 6, we studied that a firm should accept any project that has a positive net present value (NPV) u Alternative methods to take into account a company’s capital structure in evaluating investment projects – Adjusted present value (APV) – Flows to equity (FTE) – Weighted average cost of capital (WACC) Evaluation of Levered Investments

11 Finance School of Management u Current capitalization of Gcc is $1 billion u New investment requires an initial outlay of $100 billion, and annual maintenance expense is $5 million (lasts indefinitely) u The increased revenues are $20 million per year u The Gcc debt is riskless with an interest rate of 8% per year u Tax rate is 30% u The required rate of return on unlevered investments is 10% per year An Illustration: GCC Unlevered Expected Cash Flow = (1-0.3) × ($20 million - $5 million) = 0.7 × $15 million = $10.5 million NPV without Leverage = PV of Revenues-Initial Outlays = $10.5 million/0.1 -$100 million = $5 million

12 Finance School of Management The Adjusted Present Value (APV) APV= Unlevered PV + PV of Incremental Tax Shield = Unlevered PV + Tax Rate*Amount of New Debt  The amount of new debt (perpetual) created by taking the project is 20% of the increase in the market value of the firm, or 0.2*APV of the project APV= Unlevered PV + PV of Incremental Tax Shield = $105 million ×APV = $105 million / 0.94= $111.7 million ANPV= Unlevered NPV + PV of Incremental Tax Shield = $5.0 million + $6.70 million= $11.7 million

13 Finance School of Management The Flows to Equity (FTE)  The cost of equity capital, k e where k = the cost of capital with no leverage t = the tax rate r = the rate of interest on the debt (default free) d = market debt-to-equity ratio  Increase in the present value of equity E=Increase in incremental cash flow to shareholders/ke

14 Finance School of Management The Flows to Equity (FTE)  Since GCC maintain a fixed debt-to-equity ratio d = 0.20 / 0.80=0.25 we have  The expected incremental after-tax cash now to GCC's shareholders CFS = Unlevered Expected Cash F1ow-After-tax Interest Expense = $105 million -(1-t)×r×Debt = $105 million ×0.08×Debt = $105 million ×Debt

15 Finance School of Management The Weighted Average Cost of Capital  The weighted average cost of capital, WACC, is  The NPV of the project is computed as the expected unlevered after- tax annual cash flow discounted at the WACC less the initial outlay NPV = Unlevered Expected Cash Flow/WACC- Investment Cost = $10.5 million/ $100 million = $11.7 million

16 Finance School of Management Answers to the Assignments Refer to the Excel Files!

17 Finance School of Management Chapter 17: Investing in Real Options  Main Contents: The concept of real options: a series of decision flexibilities in uncertainty. Applying the Binomial model and the B-S Formula to value real options.  Answers to the Assignments: see Excel!