Microsoft Word - Document1
Assignment 08 – Capital Structure
Directions: Unless otherwise stated, answer in complete sentences, and be
sure to use co
ect English spelling and grammar. Sources must be cited in
APA format. Your response should be four (4) pages in length
Respond to the items below.
Part A: Cash Flow of Accounts Receivable
Myers and Associates, a famous law office in California, bills its clients on
the first of each month. Clients pay in the following way:
40% pay at the end of the first month
30% pay at the end of the second month
20% pay at the end of the third month
5% pay at the end of the fourth month
5% default on their bills
The actual and anticipated billings are as follows:
Give the anticipated cash flow for the first quarter of 2018 if the past billings
and anticipated billings follow this same pattern. Show your work.
Part B: Straight Bank Loan
Right Bank offers EAR loans of 9.38% and requires a monthly payment on all
loans.
a. What is the APR for these monthly loans? Show your work.
. What is the monthly payment for the following? Show your work.
1. A loan of $200,000 for six years
2. A loan of $450,000 for twelve years
3. A loan of $1,250,000 for thirty years
Part C: Selling Bonds
Astro Investment Bank has the following bond deals under way:
The bond yield in the table is the market yield before the commission is
charged. Assume that all bonds are semiannual and issued at a par value of
$1,000.
Determine the net proceeds of each bond and the cost of the bonds for each
company in terms of yield. Show your work.
Chapter 16.pdf
Financial Management: Core Concepts
Fourth Edition
Chapter 16
Capital Structure
Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved.
Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved.
Learning Objectives (1 of 2)
16.1 Explain why bo
owing rates are different based on
ability to repay loans.
16.2 Demonstrate the benefits of bo
owing.
16.3 Calculate the
eak-even EBIT for different capital
structures.
16.4 Explain the appropriate bo
owing strategy under the
pecking order hypothesis.
Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved.
Learning Objectives (2 of 2)
16.5 Develop the arguments for the optimal capital structure
in a world of no taxes and no bankruptcy and in a world
of corporate taxes with no bankruptcy costs.
16.6 Understand the static theory of capital structure and the
trade-off between the benefits of the tax shield and the
cost of bankruptcy.
Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved.
16.1 Capital Markets: A Quick Review (1 of 3)
• Companies raise funds for growth in debt and equity
markets.
• Investors have different risk preferences and companies
have varying risk profiles.
• The cost that a firm pays for its debt or the rate of return
that investors demand to purchase equity in a firm
depends largely on the firm’s debt rating and its beta or
systematic risk measure.
• Riskier firms end up paying higher yields on debt securities
and are expected to pay a higher rate of return on their
equity, thereby raising their average cost of capital.
Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved.
16.1 Capital Markets: A Quick Review (2 of 3)
Example 1: Effect of Risk on Bo
owing Rates
Mike and Agnes are two venture capitalists with fairly different risk
profiles.
On average, both investors are willing to commit $1,000,000 per project
to cutting-edge ideas and products that they think will fly.
However, Mike is more conservative in that he tends to select low-risk
projects that he thinks have at least a 50% chance of being successful.
While Agnes selects high-risk projects that have at least 20% chance of
doing well. Their success rates have tended to be right in line with their
expectations.
Based on their track records, what is the minimum rate that each
investor is willing to lend $1,000,000 at?
Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved.
16.1 Capital Markets: A Quick Review (3 of 3)
Example 1: Answe
Mike’s success rate = 5 ÷ 10 projects; Agnes’ success rate = 2 ÷ 10
projects
So, if they each lend $1,000,000 → 10 projects @ $100,000 each
For Mike, each successful project must return $1,000,000 ÷ 5 =
$200,000
For Agnes, each successful project must return $1,000,000 ÷ 2
= $500,000
Mike’s loan rate → ($200,000 − $100,000) ÷ $100,000 = 100%
Agnes’s loan rate → ($500,000 − $100,000) ÷ $100,000 = 400%
So Agnes (being more of a risk-taker) has a loan rate that is four
times higher than that of Mike.
Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved.
16.2 Benefits of Debt
• Financial leverage is the ability that owners have to use
other people’s money at fixed rates to make higher rates of
eturn than would have been possible by using all of one’s
own money. It represents one of the main benefits of
taking on debt.
• Firms that take on debt as part of their capital structure are
therefore known as leveraged firms while those that do not
are known as unlevered firms.
Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved.
16.2 (A) Earnings per Share as a Measure
of the Benefits of Bo
owing (1 of 4)
• One way to measure the benefits of leverage is by
comparing the EPS of firms with different capital structures
under good and bad economic conditions.
• Table 16.1 presents three equal-sized firms, one with no
debt, one with 50% debt, and the last one with 99.75% debt.
Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved.
16.2 (A) Earnings per Share as a Measure
of the Benefits of Bo
owing (2 of 4)
Table 16.1 Capital Structure of Three Identical Firms
Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved.
16.2 (A) Earnings per Share as a Measure
of the Benefits of Bo
owing (3 of 4)
• Assuming a cost of debt of 10% for all firms and identical EBIT ($2000),
EPS is calculated and shown in Table 16.2.
Table 16.2 Earnings per Share of Firms with Different Funding
Structures
• If the firm’s EBIT covers its interest cost, higher leverage benefits the
stockholders with a higher EPS.
Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved.
16.2 (A) Earnings per Share as a Measure
of the Benefits of Bo
owing (4 of 4)
• However, if the firm’s EBIT does not cover its interest cost, the reverse
is true, as shown in Table 16.3.
Table 16.3 Earnings per Share of Firms with Different Funding
Structures
• So leverage is a two-edged sword, benefiting firms in good times and
hurting them in bad times.
Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved.
16.3 Break-Even Earnings for Different
Capital Structures (1 of 4)
• At a certain level of EBIT, known as the
eak-even EBIT, all three
firms will have the same EPS as shown in Table 16.4.
Table 16.4 Earnings per Share of Firms with Different Capital
Structures
Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved.
16.3 Break-Even Earnings for Different
Capital Structures (2 of 4)
To calculate the
eak-even EBIT we use the following
method:
1) We first calculate the EPS of two firms, → Company 1
and Company 2; set them equal; and solve for the EBIT.
EPS = (EBIT − I) ÷ # of shares
EPS1 = (EBIT − 0) ÷ 400 = (EBIT − $500) ÷ 200
→ 400 (EBIT − $500) = 200(EBIT − 0)
→ 2EBIT − $1,000 = EBIT
→ EBIT = $1,000
Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved.
16.3 Break-Even Earnings for Different
Capital Structures (3 of 4)
2) Next, we calculate each firm’s EPS at the
eak-even
EBIT, i.e., $1,000:
Company 1’s EPS = 1,000 ÷ 400 = $2.50
Company 2’s EPS = (1,000 − 500) ÷ 200 = $2.5
Company 3’s EPS = (1,000 − 997.5) ÷ 1 = $2.5
Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved.
16.3 Break-Even Earnings for Different
Capital Structures (4 of 4)
3) Below an EBIT of $1000, e.g. $800: leverage hurts and
vice-versa as shown in Figure 16.1.
Figure 16.1 Earnings
per share and earnings
for three different
capital structures.
Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved.
16.4 Pecking Orde
• The pecking order hypothesis is based on the notion that
firms have a prefe
ed order of raising capital.
• Accordingly, it states that:
1. Firms prefer internal financing (retained earnings) first.
2. If external financing is required, firms will choose to issue the
safest or cheapest security first, starting with debt financing and
using equity as a last resort.
Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved.
16.4 (A) Firms Prefer Internal Financing
First
• Why do firms prefer internal financing first?
– It typically requires less effort,
– Avoids transactions cost,
– Avoids loss of secrecy.
Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved.
16.4 (B) Firms Choose to Issue Cheapest Security
First and Use Equity as a Last Resort (1 of 2)
• Retained earnings being limited, firms have to use other
external sources such as debt and equity.
• When they do tap the capital markets, firms tend to issue
debt first, → less costly, and leads to less loss of control,
and equity last, → too much debt can put the firm into a
isk of bankruptcy.
Copyright © 2019, 2016, 2013 Pearson