Corporate Finance Crasher 1

Embed Size (px)

Citation preview

  • 8/2/2019 Corporate Finance Crasher 1

    1/116

    Corporate Finance Crasher

    Finance and Investments Club

  • 8/2/2019 Corporate Finance Crasher 1

    2/116

    Financial Statements and Ratios

  • 8/2/2019 Corporate Finance Crasher 1

    3/116

    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

  • 8/2/2019 Corporate Finance Crasher 1

    4/116

    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

  • 8/2/2019 Corporate Finance Crasher 1

    5/116

    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%

  • 8/2/2019 Corporate Finance Crasher 1

    6/116

    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

  • 8/2/2019 Corporate Finance Crasher 1

    7/116

    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

  • 8/2/2019 Corporate Finance Crasher 1

    8/116

    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%

  • 8/2/2019 Corporate Finance Crasher 1

    9/116

    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%

  • 8/2/2019 Corporate Finance Crasher 1

    10/116

    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

  • 8/2/2019 Corporate Finance Crasher 1

    11/116

    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

  • 8/2/2019 Corporate Finance Crasher 1

    12/116

    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

  • 8/2/2019 Corporate Finance Crasher 1

    13/116

    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

  • 8/2/2019 Corporate Finance Crasher 1

    14/116

    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

  • 8/2/2019 Corporate Finance Crasher 1

    15/116

    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% -

  • 8/2/2019 Corporate Finance Crasher 1

    16/116

    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

  • 8/2/2019 Corporate Finance Crasher 1

    17/116

    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

  • 8/2/2019 Corporate Finance Crasher 1

    18/116

    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

  • 8/2/2019 Corporate Finance Crasher 1

    19/116

    Financial Management

  • 8/2/2019 Corporate Finance Crasher 1

    20/116

    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.

  • 8/2/2019 Corporate Finance Crasher 1

    21/116

    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.

  • 8/2/2019 Corporate Finance Crasher 1

    22/116

    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

  • 8/2/2019 Corporate Finance Crasher 1

    23/116

    How to reduce Agency Costs?

    Motivating Managers: ExecutiveCompensation-

    Salary

    Bonus

    ESOP

    Stock Appreciation Rights

    Sweat Equity

    EVA-linked Bonus

  • 8/2/2019 Corporate Finance Crasher 1

    24/116

    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.

  • 8/2/2019 Corporate Finance Crasher 1

    25/116

    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

  • 8/2/2019 Corporate Finance Crasher 1

    26/116

    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)

  • 8/2/2019 Corporate Finance Crasher 1

    27/116

    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

  • 8/2/2019 Corporate Finance Crasher 1

    28/116

    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

  • 8/2/2019 Corporate Finance Crasher 1

    29/116

    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

  • 8/2/2019 Corporate Finance Crasher 1

    30/116

    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

  • 8/2/2019 Corporate Finance Crasher 1

    31/116

    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

  • 8/2/2019 Corporate Finance Crasher 1

    32/116

    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

  • 8/2/2019 Corporate Finance Crasher 1

    33/116

    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

  • 8/2/2019 Corporate Finance Crasher 1

    34/116

    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?

  • 8/2/2019 Corporate Finance Crasher 1

    35/116

    Bond Mathematics

    Classifying Bonds: Issuer:

    Govt.

    Corporate

    Municipality

    Maturity; Short Medium

    Long

    Coupon Rate: Fixed

    Floating

    Zero coupon Redemption Features:

    Callable

    Putable

    Convertible

  • 8/2/2019 Corporate Finance Crasher 1

    36/116

    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)

  • 8/2/2019 Corporate Finance Crasher 1

    37/116

    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

  • 8/2/2019 Corporate Finance Crasher 1

    38/116

    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.

  • 8/2/2019 Corporate Finance Crasher 1

    39/116

    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)

  • 8/2/2019 Corporate Finance Crasher 1

    40/116

    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.

  • 8/2/2019 Corporate Finance Crasher 1

    41/116

    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.

  • 8/2/2019 Corporate Finance Crasher 1

    42/116

    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

  • 8/2/2019 Corporate Finance Crasher 1

    43/116

    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.

  • 8/2/2019 Corporate Finance Crasher 1

    44/116

    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

  • 8/2/2019 Corporate Finance Crasher 1

    45/116

    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

  • 8/2/2019 Corporate Finance Crasher 1

    46/116

    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.

  • 8/2/2019 Corporate Finance Crasher 1

    47/116

    Bond Pricing

    The present value of a debt security, V, is:

  • 8/2/2019 Corporate Finance Crasher 1

    48/116

    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?

  • 8/2/2019 Corporate Finance Crasher 1

    49/116

    Valuing a Straight Coupon Bond

    What will be the value of the bond, if the interest is paid

    semi-annually?

  • 8/2/2019 Corporate Finance Crasher 1

    50/116

    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.

  • 8/2/2019 Corporate Finance Crasher 1

    51/116

    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.

  • 8/2/2019 Corporate Finance Crasher 1

    52/116

    Term Structure

    The term structure describes the relationship

    of spot rates with different maturities.

    One needs zero rates to construct the term

    structure.

  • 8/2/2019 Corporate Finance Crasher 1

    53/116

    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

  • 8/2/2019 Corporate Finance Crasher 1

    54/116

    Example

    Maturity(years)

    Zero Rate(% cont comp)

    0.5 5.0

    1.0 5.8

    1.5 6.4

    2.0 6.8

  • 8/2/2019 Corporate Finance Crasher 1

    55/116

    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

    . . . . . .

    . . .

  • 8/2/2019 Corporate Finance Crasher 1

    56/116

    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

    . . . ..

  • 8/2/2019 Corporate Finance Crasher 1

    57/116

    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

  • 8/2/2019 Corporate Finance Crasher 1

    58/116

    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?

  • 8/2/2019 Corporate Finance Crasher 1

    59/116

    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.

  • 8/2/2019 Corporate Finance Crasher 1

    60/116

    Valuation Models

    Dividend growth at a constant rate (g): (also

    known as Gordon Model)

    OR

    OR

  • 8/2/2019 Corporate Finance Crasher 1

    61/116

    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?

  • 8/2/2019 Corporate Finance Crasher 1

    62/116

    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

  • 8/2/2019 Corporate Finance Crasher 1

    63/116

    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.

  • 8/2/2019 Corporate Finance Crasher 1

    64/116

    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

    .

    .

    .

    .

    .

    .

  • 8/2/2019 Corporate Finance Crasher 1

    65/116

    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

  • 8/2/2019 Corporate Finance Crasher 1

    66/116

    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

  • 8/2/2019 Corporate Finance Crasher 1

    67/116

    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.

  • 8/2/2019 Corporate Finance Crasher 1

    68/116

    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%.

  • 8/2/2019 Corporate Finance Crasher 1

    69/116

    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

  • 8/2/2019 Corporate Finance Crasher 1

    70/116

    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.

  • 8/2/2019 Corporate Finance Crasher 1

    71/116

    Concept of Risk and Return

  • 8/2/2019 Corporate Finance Crasher 1

    72/116

    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

  • 8/2/2019 Corporate Finance Crasher 1

    73/116

    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

  • 8/2/2019 Corporate Finance Crasher 1

    74/116

    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.

  • 8/2/2019 Corporate Finance Crasher 1

    75/116

    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.

  • 8/2/2019 Corporate Finance Crasher 1

    76/116

    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?

  • 8/2/2019 Corporate Finance Crasher 1

    77/116

    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.

  • 8/2/2019 Corporate Finance Crasher 1

    78/116

    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

  • 8/2/2019 Corporate Finance Crasher 1

    79/116

    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

  • 8/2/2019 Corporate Finance Crasher 1

    80/116

    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

  • 8/2/2019 Corporate Finance Crasher 1

    81/116

    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

  • 8/2/2019 Corporate Finance Crasher 1

    82/116

    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

  • 8/2/2019 Corporate Finance Crasher 1

    83/116

    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

  • 8/2/2019 Corporate Finance Crasher 1

    84/116

    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

  • 8/2/2019 Corporate Finance Crasher 1

    85/116

    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

  • 8/2/2019 Corporate Finance Crasher 1

    86/116

    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

  • 8/2/2019 Corporate Finance Crasher 1

    87/116

    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

  • 8/2/2019 Corporate Finance Crasher 1

    88/116

    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

  • 8/2/2019 Corporate Finance Crasher 1

    89/116

    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

  • 8/2/2019 Corporate Finance Crasher 1

    90/116

    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

  • 8/2/2019 Corporate Finance Crasher 1

    91/116

    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

  • 8/2/2019 Corporate Finance Crasher 1

    92/116

    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

  • 8/2/2019 Corporate Finance Crasher 1

    93/116

    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

  • 8/2/2019 Corporate Finance Crasher 1

    94/116

    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

  • 8/2/2019 Corporate Finance Crasher 1

    95/116

    Total Risk

  • 8/2/2019 Corporate Finance Crasher 1

    96/116

    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

  • 8/2/2019 Corporate Finance Crasher 1

    97/116

    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

  • 8/2/2019 Corporate Finance Crasher 1

    98/116

    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

  • 8/2/2019 Corporate Finance Crasher 1

    99/116

    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

  • 8/2/2019 Corporate Finance Crasher 1

    100/116

    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).

  • 8/2/2019 Corporate Finance Crasher 1

    101/116

    Beta and CAPM

  • 8/2/2019 Corporate Finance Crasher 1

    102/116

    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

  • 8/2/2019 Corporate Finance Crasher 1

    103/116

    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?

  • 8/2/2019 Corporate Finance Crasher 1

    104/116

    Capital Structure Theories

    What is Capital Structure?

  • 8/2/2019 Corporate Finance Crasher 1

    105/116

    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

  • 8/2/2019 Corporate Finance Crasher 1

    106/116

    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

  • 8/2/2019 Corporate Finance Crasher 1

    107/116

    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

  • 8/2/2019 Corporate Finance Crasher 1

    108/116

    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

  • 8/2/2019 Corporate Finance Crasher 1

    109/116

    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

  • 8/2/2019 Corporate Finance Crasher 1

    110/116

    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

  • 8/2/2019 Corporate Finance Crasher 1

    111/116

    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

  • 8/2/2019 Corporate Finance Crasher 1

    112/116

    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

  • 8/2/2019 Corporate Finance Crasher 1

    113/116

    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

  • 8/2/2019 Corporate Finance Crasher 1

    114/116

    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.

  • 8/2/2019 Corporate Finance Crasher 1

    115/116

    Cost of Capital

  • 8/2/2019 Corporate Finance Crasher 1

    116/116

    Beta