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Corporate Finance Crasher
Finance and Investments Club
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Financial Statements and Ratios
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Financial Analysis E.I.C. Framework
Economic Analysis
Industry Analysis
Company Analysis
Financial Performance Analysis Trend, Common Size, Financial Ratios, Composite Scores
Operating Performance Financial Performance per unit of operating measure
Non Financial Measures Requires primary data, typically not available in financial
reports
Sometimes data are available in industry publication
May 1, 2012 3
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Trend Analysis Base year is 100,
remaining years
numbers are % of thebase year number,therefore representcumulative rate of
growth / declinerelative to the base year
Useful for Studying growth,
Studying directional changes Identifying improvement and
deterioration in financialperformance
Trend Analysis 20x1 % 20x0 %
Sales 10,000 125 8,000 100
Less COGS (5,500) 110 (5,000) 100Gross Profit 4,500 150 3,000 100
Less Operating Exp (2,100) 105 (2,000) 100
Operating Income 2,400 240 1,000 100
Less Interest Exps (400) 100 (400) 100
Less Income Taxes (900) 225 (400) 100
Profit After Taxes 1,100 550 200 100
Fixed Assets 5,600 112 5,000 100
Current Assets 2,400 96 2,500 100
Total Assets 8,000 107 7,500 100
Current Liabilities 1,600 80 2,000 100
Long Term Debt 2,400 120 2,000 100
Equity 4,000 114 3,500 100
May 1, 2012 4
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Common Size Statements
B/S # are % of TA I/S # are % of Sales
Useful for Comparing performance
across years and firms
Identifying Strength and
Weakness of a firm by
comparing its performance
with those of its industry
peers
Identifying Improvement and
Deterioration in its financial
performance, by comparing
its performance across years
May 1, 2012 5
Common Size 20x1 % 20x0 %
Sales 10,000 100% 8,000 100%
Less COGS (5,500) (55%) (5,000) (63%)Gross Profit 4,500 45% 3,000 38%
Less Operating Exp (2,100) (21%) (2,000) (25%)
Operating Income 2,400 24% 1,000 13%
Less Interest Exps (400) (4%) (400) (5%)
Less Income Taxes (900) (9%) (400) (5%)
Profit After Taxes 1,100 11% 200 3%
Fixed Assets 5,600 70% 5,000 67%
Current Assets 2,400 30% 2,500 33%
Total Assets 8,000 100% 7,500 100%
Current Liabilities 1,600 20% 2,000 27%
Long Term Debt 2,400 30% 2000 27%
Equity 4,000 50% 3,500 47%
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Financial Ratio Analysis
Financial ratio represents a relative measure where both thenumerator and the denominator are financial numbers
Designed to illuminate some aspect of how the business is
doing and identify its Strengths and Weaknesses
Depending upon the source of the numbers, 3 groups of ratio Balance Sheet Ratio
Where both the variables are taken from the B/S
Use Ending Values of the B/S numbers in B/S Ratios
Profit and Loss Ratio Where both the variables are taken from P&L
Mixed Ratio
Where one variable is taken from B/S and the other from P&L
Use average Values of the B/S numbers in Mixed Ratios
May 1, 2012 6
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Ratio Analysis: Types of Ratios
Financial Ratios
Profitability Ratio
Activity or Efficiency Ratio
Liquidity Ratios
Leverage Ratios
Multiples or Market Ratios
May 1, 2012 7
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Profitability Ratios 1
Gross Profit (GP) Ratio
Operating Profit (OP) Ratio
Net Profit (NP) Ratio
COGS Ratio = COGS / Sales
COS Ratio = 1OP Ratio ETR = Income Tax Exps /
EBT
May 1, 2012 8
Sales
ProfitOperating
SalesProfitGross
SalesProfitNet
Profitability Ratios 20x1 20x0
Sales 10,000 8,000Less COGS -5,500 -5,000
Gross Profit 4,500 3,000
Less Operating Exp -2,100 -2,000
Operating Profit 2,400 1,000
Less Interest Exps -400 -400PBT 2,000 600
Less Income Taxes -900 -400
PAT 1,100 200
GP Ratio 45% 38%
OP Ratio 24% 13%
NP Ratio 11% 3%
COGS Ratio 55% 62%
COS Ratio 76% 87%
Effective Tax Rate 45% 67%
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Return on Assets (ROA)
Return on CapitalEmployed or Investment(ROCE or ROI)
Return on Equity
EPS = Earnings Per Share DPS = Dividends Per Share
Pay Out Ratio = DPSEPS NOPAT = EBIT * (1-ETR) = PAT + Interest
Exp * (1-ETR)
Profitability Ratios 2
May 1, 2012 9
.).( ExpMiscTAAverageNOPAT
)(EquityAverageProfitNet
)(CEAverage
NOPAT
Profitability
Ratios 220x1 20x0 Avg.
Operating Profit 2,400 1,000Less Interest Exp (400) (400)
PAT 1,100 200
Total Assets 8,000 7,500 7,750
Long Term Debt 2,400 2000 2,200Equity 4,000 3,500 3,750
Effective Tax Rate 45% 67%
NOPAT 1,320 333
Average CE 5,950
ROA 17%
ROI 22%
ROE 29%
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Activity or Efficiency Ratios 1 Total Asset Turnover
Fixed Asset Turnover
Working Capital Turnover
Current Asset Turnover
Capital EmployedTurnover
May 1, 2012 10
)( CapWIPNBAverageSales
.).( ExpMiscTAAverage Sales
)(CAAverageSales
)( CLCAAverageSales
)(CEAverageSales
Activity Ratios 20x1 20x0 Avg
Sales 10,000 8,000
Fixed Assets 5,600 5,000 5,300
Current Assets 2,400 2,500 2,450
Total Assets 8,000 7,500 7,750
Current Liabilities 1,600 2,000 1,800
Long Term Debt 2,400 2000 2,200
Equity 4,000 3,500 3,750
TA Turnover 1.29
FA Turnover 1.89
WC Turnover 15.38
CA Turnover 4.08
CE Turnover 1.68
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Activity or Efficiency Ratios 2 Inventory Days
Receivables Days
Payables Days
Operating Cycle Days
Inventory Days+Receivables DaysPayables Days
Turnover Ratio = 360/Days Ratio
May 1, 2012 11
360)( COGSInventoryAverage
360)//( SalesCredit
RBRAAverage
360)//( PurchasesCredit
PBPAAverage
Activity Ratios 20x1 20x0 Avg
Sales 10,000 8,000
Less COGS (5,500) (5,000)
Inventory 800 700 750
A/R 400 600 500
B/R 300 400 450
A/P 900 700 800
B/P 200 200 200
Purchases 5,600
Days Turnover Ratio
Inventory Days 49.1 7.3
Receivables Days 30.6 11.8
Payables Days 64.3 5.6
Operating Cycle 13.5 26.7
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Liquidity Ratios Current Ratio
Quick Ratio
Interest Expense CFO
Current Liability CFO Total Liability CFO
May 1, 2012 12
CLCA
CLInventoryCA
Liquidity Ratios 20x1 20x0
Less Interest Exps (400) (400)
Inventory 800 700
Current Assets 2,400 2,500
Current Liabilities 1,600 2,000
Long Term Debt 2,400 2,000
Total Liability 4,000 4,000
Quick CA 1,600 1,800
Current Ratio 1.50 1.25
Quick Ratio 1.00 0.90
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Leverage Ratios 1
Debt Equity Ratio
Total Debt = Long Term Debt +Current Portion of LT Debt
included in Current Liabilities +Short Term Debt.
Weight of Debt in CE
Weight of Equity in CE= 1Weight of Debt
Interest Coverage Ratio
May 1, 2012 13
EquityDebtTotal
InterestInterestPAT
RatioDEEquityDebtDebt
1
11
Leverage Ratios 20x1 20x0
Less Interest Exps (400) (400)Less Income Taxes (900) (400)
Profit After Taxes 1,100 200
Equity 4,000 3,500
Long Term Debt 2,400 2,000
LTD: Current Portion 300 500
Short Term Debt 200 400
Total Debt 2,900 2,900
Debt Equity Ratio 0.73 0.83
Weight of Debt 0.42 0.45
Weight of Equity 0.58 0.55
Interest Coverage 3.75 1.50
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Leverage Ratios 2
Debt Service Coverage
Ratio (DSCR)
Debt Related Payments = Intereston Borrowings+ CurrentPortion of LT Debt + Short
Term Debt. Financial Service
Coverage Ratio (FSCR)
Financial Payments = Intereston Borrowings + CurrentPortion of LT Debt + ShortTerm Debt + Lease RentalPayments.
May 1, 2012 14
PaymentRelatedDebtCFO
PaymentsFinancialCFO
Leverage Ratios 20x1 20x0
CFO 3,000 2,400Interest Exps 400 400
LTD: Current Portion 300 500
Short Term Debt 200 400
Lease Liability:Current Portion
- 200
Debt Related
Payment
900 1,300
Financial Payment900 1,500
DSCR 3.33 1.85
FSCR 3.33 1.60
M k t R ti d
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Market Ratios and
Multiples Market to Book Ratio
Price (Equity Total Shares#)
Dividend Yield DPS Price
Earnings Yield
EPS Price = 1 PE Ratio Price Multiples
P-E Ratio = Price EPS
P-Sales, P-CFO Multiples = P Sales or CFO per share
Total Return toShareholders= (Equity Cash Dividend + (End of thecurrent year Share PriceEnd of the last
year Share Price)) End of the last yearsShare Price
May 1, 2012 15
Market Ratios 20x1 20x0
Profit After Taxes 1,100 200
Equity 4,000 3,500
# of Shares 1,000 1,000Share Price 30 22
Capital Gains 8
Dividend 600 -
DPS 0.60 -
EPS 1.10 0.20
BV of Equity per share 4.00 3.50
MTB 7.5 6.3
Dividend Yield2.0%
-
Earnings Yield 3.7% 0.9%
P-E Ratio 27.3 110.0
P-S Ratio 3.00 2.75
P-CFO Ratio 10.0 9.2
TRS 39% -
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Drivers of ROE
ROE = Net Profit Margin
x Capital Employed Turnover
x Financial Leverage Multiplier= ROI x Financial Leverage Multiplier
Financial Leverage Multiplier = 1 + [Avg(Debt) / Avg(Equity)]
May 1, 2012 16
)(EquityAverage
IncomeNetROE
uity)Average(EqCEAverage
CEAverageSales
SalesIncomeNet )(
)(
Overall
Profitability11%
Overall
Efficiency= 1.68
Overall
Leverage= 1.59
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Drivers of ROE
NetProfit
Margin COGS%
Operating Exp%
Interest Exp%
Other Income%
Income Tax%
CapitalEmployed
Turnover FA Turnover
WC Turnover
CA Turnover
Inv Turnover
A/R Turnover
CL Turnover
A/P Turn
FinancialLeverage
Multiplier Debt Equity Ratio
Weight of Debt
Weight of Equity
May 1, 2012 17
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B/S, I/S & Other numbers usedB/S 20x1 20x0
Fixed Assets 5,600 5,000
Current Assets 2,400 2,500Inventory 800 700
A/R 400 600
B/R 300 400
Other CA 500 500Cash 400 300
Total Assets 8,000 7,500
Current Liabilities 1,600 2,000A/P 900 700
B/P 200 200
LT Debt: Current 300 500Short Term Debt 200 400
Lease Liab: Current 0 200
Long Term Debt 2,400 2,000
Equity 4,000 3,500
Total Liab & Eq. 8,000 7,500May 1, 2012 18
I/S 20x1 20x0
Sales 10,000 8,000
Less COGS (5,500) (5,000)
Gross Profit 4,500 3,000
Less Operating Exp (2,100) (2,000)
Operating Income 2,400 1,000
Less Interest Exps (400) (400)
Less Income Taxes (900) (400)
Profit After Taxes 1,100 200
Other Info. 20x1 20x0
CFO 3,000 2,400
# of Shares 1,000 1,000
Share Price $30.00 $22.00
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Financial Management
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Financial Management
Financial Management involves three decisions:
Investment Decisions
Financing Decisions
Dividend Decisions
Whether a financial decision involves investingand/or financing, it also will be concerned with twospecific factors: expected return and risk.
Expected return is the difference between potentialbenefits and potential costs. Riskis the degree ofuncertainty associated with these expected returns.
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The Agency Relationship
An agentis a person who acts forand exertspowers ofanother person or group ofpersons.
The person (or group of persons) the agentrepresents is referred to as theprincipal.
The relationship between the agent and his orher principal is an agency relationship.
There is an agency relationship between themanagers and the shareholders ofcorporations.
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Costs of Agency Relationship
There are costs involved with any effortto minimize the potential for conflict
between the principals interest and the
agents interest. These are:
Monitoring Costs
Bonding Costs
Residual Costs
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How to reduce Agency Costs?
Motivating Managers: ExecutiveCompensation-
Salary
Bonus
ESOP
Stock Appreciation Rights
Sweat Equity
EVA-linked Bonus
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Financial Markets: Debt Market
Bonds, notes, and medium-term notes areissued by corporations, the government,government agencies, and municipal bodies.
Corporate debt securities backed by specific
assets as collateral are referred to as securednotes or secured bonds.
If they are not backed by specific assets, they
are referred to as debentures. In India, bonds and debentures have different
connotations.
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Corporate Bond Market
The corporate bond market involves all bondsthat have credit risk, i.e., bonds issued by allentities other than the Central Government
This includes not just the bonds issued by
private Indian firms but, more significantly,bonds issued by sub-national agencies such asstate governments (SG) and municipalities, aswell as the Public Sector Units
Compared to the stock of central governmentbonds, issues of bonds by the stategovernment are significantly smaller
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Corporate Bond Market
Corporate debt issued by firms is either in the
form of short-term instruments called
commercial paper (CP) or corporate
debentures/bonds (CB)
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Debt Market
The Wholesale Debt Market (WDM) deals in fixedincome securities
Trades in a variety of debt instruments includingGovernment Securities, Treasury Bills and Bondsissued by Public Sector Undertakings/ Corporates/
Banks like Floating Rate Bonds, Zero Coupon Bonds,Commercial Papers, Certificate of Deposits,Corporate Debentures, State Government loans, SLRand Non-SLR Bonds issued by Financial Institutions,Units of Mutual Funds and Securitized debt by banks,
financial institutions, corporate bodies, trusts andothers
The Retail Debt Market (RDM) trades in centralgovernment long-term securities for retail investors
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Equity Market
Primary Market Secondary Market
OTC Market: are arrangements inwhich investors or their
representatives trade securities
without sharing a physical location.Stocks traded on the OTC markets
are called unlisted
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Some Concepts
Firm Value: present value of the firms cash flows.
Tricky part is determining the size, timing, and risk
of those cash flows.
Time Value of Money
Compounding/Discounting
Compounding Conversion Annual/Semi-annual/Quarterly/Continuous
Present Value Concept
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Perpetuity
Perpetuity Cash flows expected to continue forever
Growing Perpetuity
Cash flows growing at a constant rate and
continuing forever
Can g be more than r forever? Can it be more than
r for a few years?
PV=CF/i
gr
C
PV
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Annuity
Series of cash flows of equal amount occurringat regular even interval
With constant cash flows
Future Value Present Value
Growing Annuity Growing stream of cash flows with fixed maturity
T
r
g
gr
CPV
)1(
11
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What is the present value of a four-year annuity of $100
per year that makes its first payment two years from today if the
discount rate is 9%?
22.297$09.1
97.327$
0 PV
0 1 2 3 4 5
$100 $100 $100 $100$323.97$297.22
97.323$)09.1(
100$
)09.1(
100$
)09.1(
100$
)09.1(
100$
)09.1(
100$4321
4
11
tt
PV
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Day count convention
Day count convention refers to themethod used for arriving at the holding
period (number of days) of a bond to
calculate the accrued interest. the conventions followed in Indian
market are given below:
Bond market: The day count convention followedis 30/360
Money market: The day count convention
followed is actual/ 365
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Yield of a treasury bill
Yield = [(100-P)/P] X 365/D X 100
Assuming that the price of a 91 day Treasury
bill at issue is Rs.98.20. Whats the yield?
After say, 41 days, if the same Treasury bill is
trading at a price of Rs. 99, whats the yield?
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Bond Mathematics
Classifying Bonds: Issuer:
Govt.
Corporate
Municipality
Maturity; Short Medium
Long
Coupon Rate: Fixed
Floating
Zero coupon Redemption Features:
Callable
Putable
Convertible
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Bond Yield
Current yield
Yield-to-maturity (YTM)
Yield-to-call (YTC) and yield-to-put (YTP)
Bond Equivalent Yield
Annual Percentage Rate (APR)
Effective Annual Rate (EAR)
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Yield Measures
Current Yield = (Annual Rupee Amount of
interest / Price)
Yield to Maturity (YTM) = It is the interest rate
which equals the Present Value of Cash flows
with Price. YTM computed on the basis of
market conventions ( frequency and basis) is
called bond equivalent yield
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Yield to Call: The issuer of the bond may
exercise call option, if the market interest
rates are falling below the coupon rate. The
Price at which the bond may be called isreferred as Call Price. YTM computed on the
basis of Call Price instead of Redemption
price is Yield to Call.
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Bond Yield
Yield to Put: In a bond issue if an investor is
having a Put Option and YTM computed by
taking Put Price is Yield to Put.
Taxable Equivalent Yield
= Nominal Tax-free Yield / (1- Marginal Tax-
Rate)
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Bond Yield
Yield for a Portfolio: It is the interest rate that
equates the present value of cash flows of the
portfolio with market value of portfolio.
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Annual Percentage Rate
Certain annualized yields are quoted so oftenthat they are given special names.
For example, when a 6-month yield is quoted
on an annualized basis, the quote is referredto as bond equivalent yield.
When a one-month yield is quoted on anannualized basis (by multiplying one monthrate by 12), it is referred to asAnnualPercentage Rate.
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Accrued Interest
When an investor purchases a bond between
coupon payments, the investor must
compensate the seller of the bond for the
coupon earned from time of the last couponpayment to settlement date of the bond. This
amount is called accrued interest. In
computation of accrued interest days count isvery much important
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Accrued Interest
The accrued interest is calculated according tothe formulaAI = (rate X days/360) X FV
where rate = coupon rate on the GOI securityFV= face value being purchased.days = number of days between the lastcoupon payment date and the settlement
date calculated as per the 30/360convention.
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Clean and dirty price
The amount that the buyer pays the seller is
the agreed upon price plus accrued interest.
This is often referred to as the full price or
dirty price.
The price of the bond without accrued
interest is called the clean price
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Risks of Fixed Income Securities
Credit Risk: Government Securities and
Treasury Bills do not have any Credit Risk. But
other bonds carry this
Price Risk
Reinvestment Risk: All coupon payment
securities have re-investment risk
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Bond Pricing
A bond is typically issued at par value of the principalamount.
However, in the secondary market, the price of abond can fluctuate greatly from its par value.
The price of a bond is determined by:
Expected periodic cash flows
The discount rate used for each cash flow.
Value of debt security = Present value of futureinterest payments + Present value of maturity value.
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Bond Pricing
The present value of a debt security, V, is:
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A simple example
A fixed-rate bond, currently priced at 102.9,
has one year remaining to maturity and is
paying 8% coupon. Assuming the coupon is
paid semiannually, what is the yield of thebond?
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Valuing a Straight Coupon Bond
What will be the value of the bond, if the interest is paid
semi-annually?
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Bond: PriceYield Relationship
A fundamental property of a bond is that its
price changes in the opposite direction of the
change in the interest rates.
Compute the price of a bond with a par valueof Rs.1000 to be paid in ten years, a coupon
rate of 10%, and a required yield of 3%, 5%,
15% and 25%. Coupon payments are madeannually.
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Bond: Price-Yield Relationship
If the coupon rate is more than the yield,
the security is worth more than its maturity
valueit sells at a premium.
If the coupon rate is less than the yield, thesecurity is less than its maturity valueit sells
at a discount.
If the coupon rate is equal to the yield, thesecurity is valued at its maturity value.
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Term Structure
The term structure describes the relationship
of spot rates with different maturities.
One needs zero rates to construct the term
structure.
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Zero Rates
A zero rate (or spot rate), for maturity Tis the
rate of interest earned on an investment that
provides a payoff only at time T
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Example
Maturity(years)
Zero Rate(% cont comp)
0.5 5.0
1.0 5.8
1.5 6.4
2.0 6.8
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Bond Pricing
To calculate the cash price of a bond we discount
each cash flow at the appropriate zero rate
The theoretical price of a two-year bond providing a
6% coupon (face value 100) semiannually is
3 3 3
103 98 39
0 05 0 5 0 058 1 0 0 064 1 5
0 068 2 0
e e e
e
. . . . . .
. . .
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Bond Yield
The bond yield is the discount rate that makes thepresent value of the cash flows on the bond equalto the market price of the bond
Suppose that the market price of the bond in our
example equals its theoretical price of 98.39 The bond yield (continuously compounded) is
given by solving
to gety=0.0676 or 6.76%.3 3 3 103 98 39
0 5 1 0 1 5 2 0e e e e
y y y y
. . . ..
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Par Yield
The par yield for a certain maturity is thecoupon rate that causes the bond price to equal
its face value.
In our example we solve
g)compoundins.a.(withgetto 876
1002100
222
0.2068.0
5.1064.00.1058.05.005.0
.c=
ec
ec
ec
ec
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Common (Equity) Stocks
Because common stock never matures, todays value
is the present value of an infinite stream of cash
flows (i.e., dividend).
But dividends are not fixed. Not knowing the amount of the dividendsor even
if there will be future dividends makes it difficult to
determine the value of common stock.
So what are we to do?
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Basic Valuation Models
Dividend Valuation Model (DVM):
Constant dividend: Let D be the constant DPS:
The required rate of return (re) is the return shareholders
demand to compensate them for the time value of money tied up in
their investment and the uncertainty of the future cash flows from
these investments.
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Valuation Models
Dividend growth at a constant rate (g): (also
known as Gordon Model)
OR
OR
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Dividend and Earnings Growth
Growth in dividends occurs primarily as a result ofgrowth in EPS.
Growth in earnings, in turn, results from a number offactors, including (1) inflation, (2) retention ratio; and
(3) ROE.
Shareholders care about all dividends, both currentand those in the future.
If most of a stocks value is due to long-term cashflows, why do managers and analysts pay so muchattention to quarterly earnings?
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Valuation Models
Varying Dividend Growth Rate:
For many companies, it is unreasonable to assume
that it grows at a constant rate.
P0 = Present value of dividends based on short-runnon-constant rate + Present value of dividends
using constant growth rate.
ff l h
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Differential Growth Assume that dividends will grow at different
rates in the foreseeable future and then willgrow at a constant rate thereafter.
To value a Differential Growth Stock, we need
to: Estimate future dividends in the foreseeable
future.
Estimate the future stock price when the stock
becomes a Constant Growth Stock . Compute the total present value of the estimated
future dividends and future stock price at theappropriate discount rate.
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Differential Growth
)(1DivDiv 101 g
Assume that dividends will grow at rate g1 forNyears and grow at rate g2 thereafter.
2
10112 )(1Div)(1DivDiv gg
N
NN gg )(1Div)(1DivDiv 1011
)(1)(1Div)(1DivDiv 21021 gggN
NN
.
.
.
.
.
.
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Differential Growth
)(1Div 10 g
Dividends will grow at rate g1 forNyears and grow
at rate g2 thereafter
2
10 )(1Div g
N
g )(1Div 10 )(1)(1Div
)(1Div
210
2
gg
g
N
N
0 1 2
N N+1
Diff i l G h
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Differential Growth
We can value this as the sum of:
anN-year annuity growing at rate g1
T
T
A
R
g
gR
CP
)1(
)1(1 1
1
plus the discounted value of a perpetuity growing atrate g2 that starts in yearN+1
NBR
gRP
)1(
Div
2
1N
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Differential Growth
Consolidating gives:
NT
T
R
gR
R
g
gR
CP
)1(
Div
)1(
)1(1 2
1N
1
1
Or, we can cash flow it out.
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A Differential Growth Example
A common stock just paid a dividend of $2. Thedividend is expected to grow at 8% for 3 years,
then it will grow at 4% in perpetuity.
What is the stock worth? The discount rate is 12%.
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Estimates of Parameters
The value of a firm depends upon its growthrate, g, and its discount rate, R.
Where does g come from?
g = Retention ratio Return on retained earnings
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Where does R come from?
The discount rate can be broken into two
parts.
The dividend yield
The growth rate (in dividends)
In practice, there is a great deal of estimation
error involved in estimating R.
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Concept of Risk and Return
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The Concept of Risk
Whenever you make a financing or investmentdecision, there is some uncertaintyabout theoutcome.
Though the terms risk and uncertainty are often
used to mean the same thing, there is a distinctionbetween them.
Uncertainty is not knowing what is going to happen.
Risk is the degree of uncertainty.
Thus, greater the uncertainty, the greater the risk.
Types of Risks
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Types of Risks Cash flow risk
Business risk Sales risk
Operating risk
Financial risk
Default risk
Reinvestment risk Prepayment risk
Call risk
Interest rate risk
Purchasing power risk
Currency risk Portfolio risk
Diversifiable risk
Nondiversifiable risk
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Cash Flow Risk
Cash flow riskis the risk that the cash flows ofan investment will not materialize as
expected.
Business riskis the risk associated withoperating cash flows.
The greater the fixed operating costs relative
to variable operating costs, the greater theoperating risk.
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Cash Flow Risk
Financial riskis the risk associated with how acompany finances its operations.
The more fixed-cost obligations (i.e., debt) incurred
by the firm, the greater its financial risk. The cash flow risk of a debt security is default riskor
credit risk.
Default risk is affected by both business riskwhich
includes sales risk and operating riskand financial
risk.
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Reinvestment Risk
Consider two 5-year bonds-Bond X (bearing10% coupon, payable annually) and Bond Y(
Zero-coupon with 10% yield). Suppose,
intermittent coupons can be reinvested 9%,8%, 7%, 6% and 5% respectively.
Which bond has higher reinvestment risk and
why?
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Reinvestment Risk
If we compare two bonds with the same yield-to-maturity and the same time to maturity,the bond with the greatercoupon rate has
more reinvestment rate risk. Two types of risk closely related to
reinvestment risk of debt securities areprepayment riskand call risk.
There is reinvestment risk for assets otherthan stocks and bonds, as well.
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Interest Rate Risk
Interest rate riskis the sensitivity of the change in anassets value to changes in market interest rates.
Lets compare the change in the value of the
Company X bond to the change in the value of theCompany Y bond as the market interest rate changes.
Suppose that it is now January 1, Year 2. Whats the
value of the bonds if: yields remain at 10%, yield
increases to 12%; yield decreases to 8%?
k
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Interest Rate Risk
Company Ys bond value is more sensitive tochanges in yield.
For a given maturity, the greater the coupon
rate, the less sensitive the bonds value to achange in the yield. Why?
For a given coupon rate, the longer thematurityof the bond, the more sensitive thebonds value to changes in market interestrates.
h k
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Purchasing Power Risk
Purchasing power riskis the risk that the pricelevel may increase unexpectedly.
Purchasing power risk is the risk that future
cash flows may be worth less or more in thefuture because of inflation or deflation,
respectively, andthat the return on the
investment will not compensate for theunanticipated inflation.
h i i k
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Purchasing Power Risk
Consider the 11.0% and 9.1% inflation rates for the yearsYear 1and Year 2, respectively. If you borrowed Rs.1,000at the beginning of Year 1 and paid it back two yearslater. But how much is a Year 2 rupee worth relative to
beginning-of-Year 1 rupees? Financial managers need to assess purchasing power risk
in terms of both their investment decisionsmaking sureto figure in the risk from a change in purchasing power ofcash flowsand their financing decisionsunderstanding how purchasing power risk affects thecosts of financing.
C Ri k
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Currency Risk
Currency risk is the risk that the relative values of thedomestic and foreign currencies will change in the
future, changing the value of the future cash flows.
As financial managers, we need to consider currencyrisk in our investment decisions that involve other
currencies and make sure that the returns on these
investments are sufficient compensation for the risk
of changing values of currencies.
H ldi P i d R
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Holding Period Returns
The holding period return is the returnthat an investor would get when holding
an investment over a period ofn years,
when the return during year iis given as
ri:
1)1()1()1(returnperiodholding21
nrrr
H ldi P i d R E l
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Holding Period Return: Example
Suppose your investment provides the followingreturns over a four-year period:
Year Return
1 10%
2 -5%
3 20%
4 15% %21.444421.
1)15.1()20.1()95(.)10.1(1)1()1()1()1(
returnperiodholdingYour
4321
rrrr
Ri k P i
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Risk Premium
Added return obtained from investing in securitieswith greater risk
measures of risk that we discuss are variance and standard
deviation
E d R Ri k d Di ifi i
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Expected Return, Risk and Diversification
As managers, we are concerned about theoverall risk of the businesss portfolio of
assets.
The return on a portfolio (rp) is the weightedaverage of the returns on the assets in the
portfolio, where the weights are the
proportion invested in each asset.
P tf li Ri k
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Portfolio Risk
Portfolio risk depends not only on stand alone risk ofeach individual asset in the portfolio but also on theirco-movement.
A statistical measure of how two variablesin this
case, the returns on two different investmentsmove together is the covariance.
The portfolios variance depends on:
The weight of each asset in the portfolio.
The standard deviation of each asset in the portfolio.
The covariance of the assets returns.
P tf li V i
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Portfolio Variance
Let cov1,2 represent the covariance of twoassets returns. We can write the portfolio
variance as:
It can be shown that for a large portfolio of multipleof assets, the portfolio variance depends more on
the covariances than on the respective variances of
individual assets.
The Efficient Set for Two Assets
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Portfolo Risk and Return Combinations
5.0%
6.0%
7.0%
8.0%
9.0%
10.0%
11.0%
12.0%
0.0% 2.0% 4.0% 6.0% 8.0% 10.0% 12.0% 14.0% 16.0%
Portfolio Risk (standard deviation)
PortfolioReturn
% in stocks Risk Return
0% 8.2% 7.0%
5% 7.0% 7.2%10% 5.9% 7.4%
15% 4.8% 7.6%
20% 3.7% 7.8%
25% 2.6% 8.0%
30% 1.4% 8.2%
35% 0.4% 8.4%
40% 0.9% 8.6%45% 2.0% 8.8%
50.00% 3.08% 9.00%
55% 4.2% 9.2%
60% 5.3% 9.4%
65% 6.4% 9.6%
70% 7.6% 9.8%
75% 8.7% 10.0%80% 9.8% 10.2%
85% 10.9% 10.4%
90% 12.1% 10.6%
95% 13.2% 10.8%
100% 14.3% 11.0%
We can consider otherportfolio weights besides
50% in stocks and 50% in
bonds
100%
bonds
100%
stocks
The Efficient Set for Two Assets
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Portfolo Risk and Return Combinations
5.0%
6.0%
7.0%
8.0%
9.0%
10.0%
11.0%
12.0%
0.0% 2.0% 4.0% 6.0% 8.0% 10.0% 1 2.0% 14.0% 1 6.0%
Portfolio Risk (standard deviation)
P
ortfolioReturn
% in stocks Risk Return
0% 8.2% 7.0%
5% 7.0% 7.2%
10% 5.9% 7.4%
15% 4.8% 7.6%
20% 3.7% 7.8%
25% 2.6% 8.0%
30% 1.4% 8.2%
35% 0.4% 8.4%
40% 0.9% 8.6%
45% 2.0% 8.8%
50% 3.1% 9.0%
55% 4.2% 9.2%
60% 5.3% 9.4%
65% 6.4% 9.6%
70% 7.6% 9.8%
75% 8.7% 10.0%
80% 9.8% 10.2%
85% 10.9% 10.4%
90% 12.1% 10.6%
95% 13.2% 10.8%
100% 14.3% 11.0%
The Efficient Set for Two Assets
100%
stocks
100%bonds
Note that some portfolios are
better than others. They have
higher returns for the same level of
risk or less.
The Efficient Set for Many Securities
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The Efficient Set for Many Securities
The section of the opportunity set above theminimum variance portfolio is the efficient frontier.
return
P
minimum
variance
portfolio
Individual Assets
Riskless Borrowing and Lending
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Riskless Borrowing and Lending
Now investors can allocate their money acrossthe T-bills and a balanced mutual fund.
100%
bonds
100%
stocks
rf
return
Balanced
fund
Riskless Borrowing and Lending
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Riskless Borrowing and Lending
With a risk-free asset available and the efficient frontier
identified, we choose the capital allocation line with thesteepest slope.
ret
urn
P
rf
Diversifiable and Non diversifiable Risks
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Diversifiable and Non-diversifiable Risks
We refer to the risk that goes away as we add assetsto a portfolio as diversifiable risk (also known asunsystematic risk).
We refer to the risk that cannotbe reduced by
adding more assets as nondiversifiable risk (alsoknown as systematic risk).
The idea that we can reduce the risk of a portfolio byintroducing assets whose returns are not highly
correlated with one another is the basis ofmodernportfolio theory (MPT).
Diversifiable and Nondiversifiable Risks
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Total Risk
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Total Risk
Total risk = systematic risk + unsystematic risk
The standard deviation of returns is a measure
of total risk.
For well-diversified portfolios, unsystematic
risk is very small.
Consequently, the total risk for a diversified
portfolio is essentially equivalent to thesystematic risk.
The Capital Asset Pricing Model
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The Capital Asset Pricing Model
William Sharpe took the idea that portfolio return andrisk are the only elements to consider and developed amodel that deals with how assets are priced.
This model is referred to as the capital asset pricing
model (CAPM). All the assets in each portfolio, even on the frontier, have
some risk.
However, regardless of the level of risk one chooses, one
can get the highest expected return by a mixture of aportfolio in the efficient frontier and a risk free asset(lending or borrowing).
Capital Market Line
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Capital Market Line
This line is referred to as the capital market line(CML).
If the portfolios along the capital market line are thebest deals and are available to all investors, it follows
that the returns of these risky assets will be priced tocompensate investors for the risk they bear relativeto that of the market portfolio.
The CML specifies the returns an investor can expect
for a given level of risk.
CAPM
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CAPM
The CAPM uses this relationship between expectedreturn and risk to describe how assets are priced.
The CAPM specifies that the return on any asset is afunction of the return on a risk-free asset plus a risk
premium. The return on the riskfree asset is compensation for
the time value of money.
The risk premium is the compensation for bearingrisk.
CAPM
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CAPM
The expected return on an individual asset isthe sum of the expected return on the risk-
free asset and the premium for bearing
market risk.
If we represent the expected return on each asset and its beta as a
point on a graph and connect all the points, the result is the security
market line (SML).
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Beta and CAPM
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Beta and CAPM
A portfolio that combines the risk-free assetand the market portfolio has an expected
return of 12% and a SD of 18%. The risk-free
rate is 5%, and the expected return on themarket portfolio is 14%. Assume CAPM holds.
What expected rate of return would a security
earn if it had a 0.45 correlation with themarket portfolio and a SD of 40%?
SML
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SML
Suppose you observe the following situation: Security: Pete Corp.
Beta 1.3
E(Return) 23%
Repete Co
Beta 0.6
E(Return) 13%
Assume that securities are correctly priced. Based on CAPMwhat is the expected Rm? What is the risk-free rate?
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Capital Structure Theories
What is Capital Structure?
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What is Capital Structure?
The combination of debt and equity used tofinance a firms projects is referred to as itscapital structure.
The capital structure of a firm is some mix ofdebt, internally generated equity, and newequity.
But what is the right mixture?
Why do some industries tend to have firmswith higher debt ratios than other industries?
M&M Hypothesis
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M&M reasoned that if the following conditions hold, the value of the firmis not affected by its capital structure:
Condition 1: Individuals and corporations are able to borrow and lendat the same terms (referred to as equal access).
Condition #2: There is no tax advantage associated with debt financing(relative to equity financing).
Condition #3: Debt and equity trade in a market where assets that aresubstitutes for one another trade at the same price. This is referred toas a perfect market.
Condition #4: There are no bankruptcy costs
Condition #5: All cash flow streams are perpetuities (i.e., no growth)
Condition #6: Corporate insiders and outsiders have the sameinformation (i.e., no signalling opportunities)
Condition #7: Managers always maximize shareholders wealth (i.e., no
agency cost) Condition # 8: Firms only issue two types of claims: risk-free debt and
(risky) equity
Condition # 9: Operating cash flows are completely unaffected bychanges in capital structure
Condition # 10: All firms are assumed to be in the same risk class
(operating risk)
M&M Hypotheses
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M&M Hypotheses
Proposition I (1958): World without tax The market value of a firm is independent of its capital structure
and is given by capitalizing its expected return at the rate Kuappropriate to its risk class.
Proposition II: World with only corporate tax The market value of a levered firm is equal to market value of
the unlevered firmplus present value of tax shield on debt
Proposition III (Miller, 1977): World with both personal
and corporate tax
Personal Tax and Capital Structure
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p If debt income (interest) and equity income (dividends and
capital appreciation) are taxed at the same rate, the interest
tax shield is still D and increasing leverage increases the valueof the firm
If debt income is taxed at rates higher than equity income,some of the tax advantage to debt is offset by a taxdisadvantage to debt income. Whether the tax advantage
from the deductibility of interest expenses is more than orless than the tax disadvantage of debt income depends on:the firms tax rate; the investors tax rate on debt income; andthe investors tax rate on equity income. But since differentinvestors are subject to different tax rates (for example,pension funds are not taxed), determining this is a problem
If investors can use the tax laws effectively to reduce to zerotheir tax on equity income, firms will take on debt up to thepoint where the tax advantage to debt is just offset by the taxdisadvantage to debt income
Trade-off Theory of Capital Structure
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Trade off Theory of Capital Structure
A firms debt equity decision is a trade-off betweeninterest tax shields and the cost of financial distress.
It recognises that target debt ratios may vary from firm to
firm.
Unlike M&M theory, it avoids extreme predictions and
rationalises moderate debt ratios.
Higher profits imply more debt servicing capacity and
more taxable income to shield and so should give a
higher target debt ratio.
Capital Structure and Financial Distress
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Capital Structure and Financial Distress
Costs of Financial Distress: Cost of forgoing a long term profitable project
Cost of lost sales
Costs associated with suppliers. Legal costs
Value of the firm = Value of the firm if all-
equity financed + Present value of the interesttax shield Present value of financial distress
Pecking Order Theory
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Pecking Order Theory
Firms prefer using internally generated capital (retainedearnings) to externally raised funds (issuing equity or debt).
Firms try to avoid sudden changes in dividends.
When internally generated funds are greater than needed forinvestment opportunities, firms pay off debt or invest inmarketable securities.
When internally generated funds are less than needed forinvestment opportunities, firms use existing cash balances orsell off marketable securities.
If firms need to raise capital externally, they issue the safestsecurity first; for example, debt is issued before preferredstock, which is issued before common equity.
Signaling Theory
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Signaling Theory
MM assumed that investors have the sameinformation about a firms prospects as its
managers- this is called symmetric
information. Agency Cost
Optimal Capital Structure
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Optimal Capital Structure
The mix of debt and equity that maximizes thevalue of the firm is referred to as the optimalcapital structure.
So what good is this analysis of the tradeoff
between the value of the interest tax shieldsand the costs of distress if we cannot apply itto a specific firm?
While we cannot specify a firms optimal
capital structure, we do know the factors thataffect the optimum.
Capital Structure: Different Industries
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Capital Structure: Different Industries
The greater the marginal tax rate, the greater the benefitfrom the interest deductibility and, hence, the morelikely a firm is to use debt in its capital structure.
The greater the business risk of a firm, the greater the
present value of financial distress and, therefore, the lesslikely the firm is to use debt in its capital structure.
The greater extent that the value of the firm depends onintangible assets, the less likely it is to use debt in itscapital structure.
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Cost of Capital
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Beta