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Industry Effects
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Financing Decision
Debt (Utang) ?
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Financial Risk
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Additional business risk concentrated on common stockholders when financial leverage is used. (Tambahan risiko jika pinjaman digunakan)
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Business Risk
Uncertainty in future Net Profit from Operations* (Ketidakpastian laba operasi di myad) * = EBIT (Earning Before Interest and Taxes) = Laba Usaha
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1-6
Financial Risk
Consider Two Firms
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Both firms have same EBIT of 3 M. They differ only with respect to use of debt.
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1-8
Impact of Leverage (Debt) on Returns Firm U EBIT Interest EBT Taxes (40%) NI ROE
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1-9
Now consider the fact that EBIT is not known with certainty. What is the impact of uncertainty on stockholder profitability and risk for Firm U and Firm L?
Continued
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Prasetiya Mulya Business School
Financial Risk
Firm U: Unleveraged Bad Economy Avg. Good
1-10
Prob. 0.25 EBIT 2,000 Interest 0 EBT 2,000 Taxes (40%) 800 NI 1,200
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Financial Risk
Firm L: Leveraged Economy Bad Avg. Prob.* 0.25 0.50 EBIT* 2,000 3,000 Interest 1,200 1,200 EBT 800 1,800 Taxes (40%) 320 720 NI 480 1,080 *Same as for Firm U.
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1-11
Financial Risk
Firm U ROE Firm L ROE Bad 6.0% Bad 4.8% Avg. 9.0% Avg. 10.8% Good 12.0% Good
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16.8%
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Business Risk
Uncertainty about future pre-tax operating income (EBIT).
Probability
Low risk High risk
1-13
E(EBIT)
EBIT
Note that business risk focuses on operating income, so it ignores financing effects.
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Prasetiya Mulya Business School
Business Risk
Factors That Influence Business Risk
1-14
Uncertainty about demand (unit sales). Uncertainty about output prices. Uncertainty about input costs.
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Business Risk
What is DOL?
1-15
Operating leverage is the change in EBIT caused by a change in quantity sold. The higher the proportion of fixed costs within a firms overall cost structure, the greater the operating leverage.
(More...)
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1-16
Probability
EBITL
EBITH
In the typical situation, higher operating leverage leads to higher expected EBIT, but also increases risk.
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Prasetiya Mulya Business School
1-17
Signaling theory
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1-18
MM relationship between value and debt when corporate taxes are considered.
Value of Firm, V VL TD VU Debt
0
Under MM with corporate taxes, the firms value increases continuously as more and more debt is used.
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Prasetiya Mulya Business School
Trade-off Theory
MM theory ignores bankruptcy (financial distress) costs, which increase as more leverage is used. At low leverage levels, tax benefits outweigh bankruptcy costs. At high levels, bankruptcy costs outweigh tax benefits. An optimal capital structure exists that balances these costs and benefits.
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Signaling Theory
1-20
MM assumed that investors and managers have the same information. But, managers often have better information. Thus, they would: Sell stock if stock is overvalued. Sell bonds if stock is undervalued. Investors understand this, so view new stock sales as a negative signal.
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A second agency problem is the potential for underinvestment. Debt increases risk of financial distress. Therefore, managers may avoid risky projects even if they have positive NPVs.
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1-23
Percent financed with debt, wd rd 0% 20% 8.0% 30% 8.5% 40% 10.0% 50% 12.0% If company recapitalizes, debt would be issued to repurchase stock.
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Prasetiya Mulya Business School
1-24
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1-25
The Cost of Equity for wd = 20% Use Hamadas equation to find beta: bL = bU [1 + (1 - T)(D/S)] = 1.0 [1 + (1-0.4) (20% / 80%) ] = 1.15 Use CAPM to find the cost of equity: rs = rRF + bL (RPM)
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What other factors would managers consider when setting the target capital structure?
Debt ratios of other firms in the industry. Pro forma coverage ratios at different capital structures under different economic scenarios. Lender and rating agency attitudes (impact on bond ratings).
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Prasetiya Mulya Business School
1-30
Reserve borrowing capacity. Effects on control. Type of assets: Are they tangible, and hence suitable as collateral?
Tax rates.
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1-31
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COST OF CAPITAL
Cost of capital is the minimum expected rate of return that the market requires in order to attract funds for a particular investment with a given level of risk
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Should we focus on ex-post (historical) costs or ex-ante (expected) costs? The cost of capital is used primarily to make decisions which involve raising and investing new capital. So, we should focus on ex-ante costs.
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Cost of Debt
Interest is tax deductible, so
kd(1 - T)
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Cost of Equity
What are the two ways that companies can raise common equity?
1-37
Companies can issue new shares of common stock. Companies can reinvest earnings.
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Cost of Equity
Three ways to determine the cost of equity (ks)
1-38
1. CAPM: ks 2. DCF: ks
= kRF + b(RPM).
= D1/P0 + g.
3. Own-Bond-Yield-Plus-Risk Premium: ks = kd + RP
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ke = D1/Po + g
Suppose Charoen Pokphand Indonesia has been earning 20% on equity (ROE = 20%) and retaining 25% (dividend payout ratio or DPO = 75%), and this situation is expected to continue. Whats the expected future g?
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1-41
Retention growth rate: g = b(ROE) = 0.25(20%) = 5% b = Fraction retained = 1-Payout ratio g = 5% given earlier.
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ks = D1/Po + g
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3. Bond-Yield-Plus-Risk-Premium
Estimating ks using the own-bond-yield-plus-riskpremium method
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Method
Estimate
CAPM
DCF
20.40%
20.18%
kd + RP
Average
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20.00%
20.19%
Prasetiya Mulya Business School
1-45
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1-46
Calculating WACC
Cap.Comp. Weight Debt 60% Common Eq. 40% 100% Comp.Cost Product 9.0%*) 5.4% 20.19% 8.01% WACC= 13.41%
*) After-tax cost of debt = Interest rate Tax savings = kd - kdT = kd (1-T) = 12% (1-25%) = 9%
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4 Mistakes to Avoid
Never base the cost of debt on the coupon rate on a firms existing debt.
Never use the historical average Never use the current Book Value capital structure to estimate the weights Always remember that capital components are funds that come from investors
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