Capital Structure

Conclusion

Target Capital Structure

• Target capital structure is a function of– expected profitability

– riskiness of operations

– vulnerabilities to outside constituencies

• Steps in the Analysis– analyze operating profits

– determine funds needs

– evaluate vulnerabilities

Analysis

• Determine Reasonable Worst CaseOperating Profit Margin– historical levels and volatility

– future risks

– competitive environment

Analysis

• Determine Vulnerabilities– pro forma to determine need for capital market

access

– competitive environment

– market demand

– distributor interests

– workforce

– Suppliers

Quantification

• Analysis of operating profitability and riskleads to RWC OPM

• Analysis of capital efficiency leads toCap/Sales ratio

• Analysis of vulnerabilities leads to Cushion– very few vulnerabilities (AHP) h=1

– moderate vulnerability (HCA) h=2

– very vulnerable (MF) h=3

Quantification

• Target Capital structure

(1/h)*(RWC OPM)*(1/CS)*(1/r)

h = “cushion)

CS = capital/Sales ratio

r = interest rate on debt

Comments

• The formula summarizes the analysis thatprecedes it

• No formula can give The Answer

• Provides framework for further analysis ofthe target capital structure decision

Implementation

• Equity is difficult to raise– if in default, may be impossible to raise equity

at any price (MF)

– a surprise issue of equity can lead to asubstantial stock price decline (AT&T)

• Unless substantially under-levered (AHP)constantly be looking for equity

Strategies for equity Issue

• Provide for small, regularly timed equityissues– Pension fund

– dividend reinvestment

– equity issues to market

• Keep analysts informed about company

Equity Issues

• Issue equity at times when informationaldifferences are likely to be small– Low risk times

– after major announcements

• Explain reasons for equity issue withoutcompromising competitive position– capital budget

– analysis of target capital structure

Corporate Finance

• Three major corporate finance questions– How much money does the firm need? X

– How should the firm raise the funds? X• Target capital structure

• Implementation

– What should the firm do with the funds?

Capital Budgeting

• Should the firm undertake a “project”?

• Involves initial investment and subsequentcash flows as a result of this investment

• Do the subsequent cash flows justify theinitial investment?

• Is the “value” of the cash flows greater thanthe amount of the initial investment?

Projects

• “project” should be broadly construed– buy a bond

– buy a stock

– buy new machinery

– build a new plant

– develop a product line

– start a price war

– acquire another company

Capital Budgeting Steps

• Define the project– identify sequence of decisions

– identify sequence of events and consequences

• Identify cash flows– Incremental, after-tax, expected, operating cash

flows

Cash Flows

• Incremental– Cash flows due to the project--those associated

with its decisions and consequences

• After tax– take account of all tax effects

• Expected– consider various possibilities and weigh by

associated probabilities

Cash Flows

• Operating– Ignore financing related cash flows

• proceeds of security issues

• dividend or interest payments

• Cash Flows– some items are accounting expenses, but not

cash expenses--ignore them

Capital Budgeting Steps

• Characterize project

• Determine incremental cash flows

• Evaluate Cash Flows

Evaluating Cash Flows

Example Project

time 0 1 2 3 4

cash -1000 250 350 450 550

Evaluating Cash Flows

• Payback– time at which cash flows cover initial

investment

time 0 1 2 3 4

cum cf -1000 -750 -400 50 600

payback = 3 years

• Ignores time after payback

• Only partially reflects timing of cash flows

Evaluating cash flows

• Average Rate of Return– (average of positive cf’s)/(total investment)

example ARR = 400/1000 = 40%

• Timing of cash flows irrelevant

• Not distinguish scale of project

Time Value of Money

• A dollar today is worth more than a dollarin a year– have the option of consuming a dollar today

immediately

– one can invest the dollar and have more than adollar for consumption in one year

• Cash flow evaluation techniques that ignorecash flow timing may lead to poor decisions

Present Value

• “Strip” prices (or their yields) tell us howthe market values future dollars– Dealer buys Treasury bond and puts in trust

– issues security for each cash flow from thatbond--a strip

Strip Prices

Maturity price yield

11/99 95:14 4.45%

11/00 91:18 4.36%

11/01 87:13 4.43%

11/02 84:15 4.20%

11/03 79:17 4.49%

11/04 75:24 4.65%10/27/98 wsj

Present value

• The value of a dollar in “a” years is worth

1/(1+strip yield)ª

• While strip yields vary with time, we willignore this

Present Value

• Reason in the following way

If you are promised 100 in a year, you figurethat you can invest X at a rate r for one yearto get 100. That is:

X(1+r) = 100 or X = 100/(1+r)

For example, r = 5% X = 100/1.05 = 95.24

Having 100 in one year is like having 95.24now.

Present Value

• Being promised 100 in two years

If invest X for two years, will have X(1+r) inone year and X(1+r)(1+r) in two years

X = 100/(1+r)²

If r = .05, X = 100/(1.05)² = 90.70

Example

-1000 250 350 450 550

Suppose interest rate is 5%

Present value of future cash flows is

250*.9524+350*.907*450*.864*550*.823

= 1396.77 which exceeds 1000

Net Present Value of Project is

-1000+1396.77 = 396.77

Present Value

Borrow at 5%, and use cf to payoff borrowing

begin 1000 800 490 64.5

int 50 40 24.5 3.225

pmt 250 350 450 550

end 1000 800 490 64.5 482.275

Left with surplus of 482.275 at year 4

present value is 482.275*.8227 = 396.77

Observations

• Note that net present value calculation takesaccount of the cost of financing the project

• This is why project cash flows should notreflect financing issues

• NPV > 0 means that the cash flowsgenerated justify the cost of financing theinitial investment

Special Formulae

• Perpetuity

The present value of receiving “a” foreverwhen the discount rate is r is

PV = a/r

• Perpetuity with growth

The present value of receiving a, then a(1+g),then a(1+g)², etc is

PV = a/(r-g) for g<r

Internal Rate of Return

• Given a project, can ask what is the highestdiscount rate (cost of financing)--Theanswer is called the Internal Rate of Return(IRR)

Example Project

Calculate NPV for various discount rates

r NPV0 600

5% 397

10% 230

15% 92

18% 21

19% -1

20% -23

IRR

NPV

r

NPV(r)

IRR0

IRR Rule

• Accept project if IRR exceeds discount rate

• Some care needed in application– if cash flows are not “nice” IRR can be

misleading--watch out if cash flow pattern is

(-,+,…,+,-) for example

– It is difficult to compare projects

Other PV applications

• NPV = 0 means cash flows just pay off theloan.

• That is, the present value of loan payments,at the loan interest rate equals the amountborrowed

What are the monthly payments on $200,000,7%, 20 year mortgage

200,000 = PV(x,x,…,x; 7/12%)

Mortgage

X = pmt(.00583,240,200000) = 1550.60

After paying the mortgage for 10 years, howmuch principle is owed?

principle = pv(.00583, 120, 1550.60)

= 133547.34

Application

You need, cf1, cf2, … , cfN for the next Nperiods. You have an investment withguaranteed return r per period. How muchdo you need to invest now?

Invest now the Present Value of cf1, cf2 etc.at the discount rate r

Example

You need cash flows

500, 200, 1000 at the end of the next threeyears. You need to invest, at 5%,

500*.952+200*.907+1000*.864 = 1521.43

Example

Begin 1521.43 1097.50 952.38

int 76.07 54.88 47.62

take 500.00 200.00 1000.00

end 1521.43 1097.50 952.38 0.00