ASSESSING LONG-TERM DEBT, THE TRADITIONAL APPROACH

EQUITY, AND CAPITAL STRUCTURE  INVERSE RELATIONSHIP BETWEEN WEIGHTED

COST OF CAPITAL AND
CAPITAL MARKET VALUE OF THE FIRM
• It refers to investor supplied funds, debt, preferred  AS WACC INCREASES, MV OF FIRM
shares, ordinary (common)equity and retained earnings. DECREASES
• It is frequently defined to include only long-term debt,  AS WACC DECREASES, MV OF THE FIRM
that is, debt due in more than year. INCREASES
• It is the aggregation of items appearing on the left hand I. THE TRADITIONAL APPROACH – FORMULAS
side of the balance sheet minus current liabilities except
short-term bank loans.
CAPITAL STRUCTURE
 It refers to the mix of debt, preferred stock and
ordinary (common) equity that the firm uses to
finance the firms assets.
 Firms can and do change their capital structures in
the longer term. It is therefore necessary to analyze
factors that affect the firm's decision to change the
funding mix.
 The financial manager's objective in making capital
structure decisions is to find the financing mix that
maximizes the value of the firm. This structure is
called the optimal capital structure.
Why capital structure changes over time? I. THE TRADITIONAL APPROACH
Firm's actual capital structure change over time and for SAMPLE PROBLEM
two quite differentreasons: Brandon’s Health Center (BHC) has no debt but is
 Deliberate Management Actions considering two plans to add leverage. Plan A – Issue
 Market Actions P200,000 bond Plan B – Issue P300,000 bonds
CAPITAL STRUCTURE THEORY he proceeds from both proposals shall be used to return
These theories address two questions: the same amount of common stock. Management wants
1. Can a firm increase shareholder wealth by replacing to evaluate the impact of increasing BHC’s financial
some of its equity with debt? leverage. Data about the corporation’s current and
2. And, if so, how much debt should it use? proposed capital structure follow:
Three theories of capital structure are examined:
1. the traditional approach
2. the Franco Modigliani and Merton Miller approach;
and
3. the contemporary approach.
I. THE TRADITIONAL APPROACH
 It suggests that a firm can lower its weighted
average cost of capital and increase its market
value by the judicious use of financial leverage.
 This theory suggests that there is a trade off
between cheaper debt and higher priced equity that
leads to an optimal capital structure.
 The cost of capital and the firm's value are not
independent of its capital structure
I. THE TRADITIONAL APPROACH
SAMPLE ILLUSTRATION
 II. THE THE MODIGLIANI AND MILLER APPROACH
PROPOSITION II – SAMPLE PROBLEM
Rocky Road Corporation has earnings before interest
and taxes of P750,000 and a 34% corporate tax rate.
The firm’s before-tax cost of debt is 10% and its cost of
equity in the absence of borrowing is 15%. Assume the
MM approach with corporate taxes.
1. What is the market value of Rocky Road with no
leverage?
2. What is the total market value of the firm with
P1,000,000 in debt?

Rocky Road Corporation has earnings before interest

and taxes of P750,000 and a 34% corporate tax rate.
The firm’s before-tax cost of debt is 10% and its cost of
II. THE THE MODIGLIANI AND MILLER APPROACH equity in the absence of borrowing is 15%. Assume the
 It is a capital structure theory named after Franco MM approach with corporate taxes.
Modigliani and Merton Miller. q Modigliani and 1. What is the market value of Rocky Road with no
Miller advocate capital structure irrelevancy theory, leverage?
which suggests that the valuation of a firm is Value of unlevered firm =750,000 (1−0.34)
irrelevant to a company’s capital structure. Whether 0.15
a firm is high on leverage or has a lower debt Value of unlevered firm =495,000
component in the financing mix has no bearing on 0.15
the value of a firm. Value of unlevered firm = 3,300,000
 MM theory proposed two propositions.
1. PROPOSITION I (PERFECT WORLD APPROACH) - Rocky Road Corporation has earnings before interest
It says that the capital structure is irrelevant to the value and taxes of P750,000 and a 34% corporate tax rate.
of a firm. The value of two identical firms would remain The firm’s before-tax cost of debt is 10% and its cost of
the same,and value would not affect the choice of equity in the absence of borrowing is 15%. Assume the
finance adopted to finance the assets. The value of a MM approach with corporate taxes.
firm is dependent on the expected future earnings. It is 2. What is the total market value of the firm with
when there are no taxes. P1,000,000 in debt?
2. PROPOSITION II (WITH CORPORATE TAXES) - It Value of levered firm = 3,300,000+ (interest exp*tax
says that the financial leverage boosts rate) interest
the value of a firm and reduces WACC. It is when tax rate
information is available. Value of levered firm = 3,300,000 + 100,000× 0.34
II. THE THE MODIGLIANI AND MILLER APPROACH 0.10
PROPOSITION I (PERFECT WORLD) ASSUMPTIONS Value of levered firm = 3,300,000 + 340,000
 There are no taxes. Value of levered firm = 3,640,000
 Transaction cost for buying and selling securities,
as well as the bankruptcy cost, is nil.
 There is a symmetry of information. This means
that an investor will have access to the same
information that a corporation would, and investors
will thus behave rationally.
 The cost of borrowing is the same for investors and
companies.
 There is no floatation cost, such as an underwriting
commission, payment to merchantbankers,
advertisement expenses, etc.
 There is no corporate dividend tax.
II. THE THE MODIGLIANI AND MILLER APPROACH
PROPOSITION II (WITH CORPORATE TAXES)
III. THE CONTEMPORARY APPROACH – TRADE-
OFF THEORY
v The contemporary approach allows for the possibility
that the firm may go bankrupt. This implies that the firm CAPITAL STRUCTURE POLICY
's debt holders will have to allow for the possibility that  It involves a choice between risk and expected
they might not receive everything they have been returns associated with the firm's financing mix.
promised.  The capital structure that balances risk and return
to maximize the value of the firm is the "optimal
III. THE CONTEMPORARY APPROACH – TRADE- capital structure".
OFF THEORY  The determination of a firm's optimal capital
structure is theoretically possible but financial
managers cannot determine with precision the
percentage of debt that will maximize the market
value of the firm.
CAPITAL STRUCTURE POLICY:
EBIT-EPS ANALYSIS
 One commonly used analytical technique used to
evaluate various capitalstructures in order to select
the one that maximizes a firm's earnings per
shareis the EBIT - EPS analysis.
ASSUMPTIONS FOR CAPITAL STRUCTURE
 This approach measures the impact of financing
THEORIES
alternatives on EPS at different levels of EBIT.
 1. Financing occurs only through two types of
 Another objective of EBIT - EPS analysis is to
capital: long-term debt and common stock
determine the EBIT EPS indifference or breakdown
 2. The firm's investment decision is fixed, but its
points between the various financing choices.
capital structure can be changed by issuing bonds,
 An indifference point is the level of EBIT where
repurchase stock or issuing stock to retire debt.
EPS of a firm is the same,regardless of which
 3. There are no taxes or bankruptcy costs (only for
alternative capital structures are employed.
MM Proposition I)
EBIT-EPS ANALYSIS: ILLUSTRATION
 4. All earnings are paid out as dividends.
Lavida Equipment Company's current capital structure
 5. Net operating income, also called earnings
consists of 8% debt with a market value and book value
before interest and taxes (EBIT),is constant.
of P4,000.000 and 200,000 shares of outstanding
 6. Business risk is constant.
common stock with a market value of P15,000.000. The
THE DIFFERENT FACTORS INFLUENCING
firm is considering a P6,000,000 expansion program
OPTIMAL CAPITAL STRUCTURE:
using one of the following financing plans.
1. Control
 Plan I: Sell additional debt at 10% interest
2. Risk
 Plan II: Sell preferred shares with a 10.5% dividend
3. Income
yield
4. Cost of Capital
 Plan III: Sell new ordinary equity securities at P150
5. Financial Leverage
per share. The corporate tax rate is 34%. Ignore
6. Flexibility
flotation costs. Consider EBIT of P2,500,000 after
7. Tax Consideration
the expansion.
8. Timing
9. Profitability
10. Marketability

BUSINESS AND FINANCIAL RISK

From the viewpoint of the corporation, there are two
dimensions of risk, namely:
 1. Business risk - refers to the riskiness of the
firm's assets if no debt is used;
 2. Financial risk- refers to the additional risk
placed on the ordinary equity
shareholders as a result of using debt.
BUSINESS RISK
 Business risk is the single most important
determinant of capital structure and it represents
the amount of risk that is inherent in the firm's
operations even it uses no debt financing.
 It is the equity risk that comes from the nature of
the firm's operating activities. The most commonly
used measure of business risk is the standard
deviation of the firm's return on invested capital or
ROIC.
 3. In general, which of the following will tend to occur if you
randomly add additional stocks to your portfolio, which
currently consists of only three stocks?

a. The expected return of your portfolio will usually

decline.
b. The company-specific risk of your portfolio will usually
decline, but the market risk will tend to remain the
same.
c. Both the company-specific risk and the market risk of
your portfolio will decline.
d. The market risk and expected return of the portfolio
will decline.
e. The company-specific risk will remain the same, but
the market risk will tend to decline.

4. Assume that the risk-free rate is 5 percent. Which of the

following statements is most correct?

a. If a stock’s beta doubles, the stock’s required return

will also double.
b. If a stock’s beta is less than 1.0, the stock’s required
return is less than 5 percent.
c. If a stock has a negative beta, the stock’s required
return is less than 5 percent.
d. All of the statements above are correct.
e. None of the statements above is correct.

5. Assume that the risk-free rate remains constant, but that

the market risk premium declines. Which of the following
is likely to occur?

a. The required return on a stock with a beta = 1.0 will

remain the same.
b. The required return on a stock with a beta < 1.0 will
1. The risk-free rate is 6 percent. Stock A has a beta of 1.0, decline.
while Stock B has a beta of 2.0. The market risk premium c. The required return on a stock with a beta > 1.0 will
(kM – kRF) is positive. Which of the following statements is increase.
most correct? d. Statements b and c are correct.
e. All of the statements above are correct.
a. Stock B’s required rate of return is twice that of
Stock A.
b. If Stock A’s required return is 11 percent, the 6. A stock with an actual return that lies above the security
market risk premium is 5 percent. market line has:
c. If the risk-free rate increases (but the market risk a. more systematic risk than the overall market.
premium stays unchanged), Stock B’s required b. more risk than that warranted by CAPM.
return will increase by more than Stock A’s. c. a higher return than expected for the level of risk
d. Statements b and c are correct. assumed.
e. All of the statements above are correct d. less systematic risk than the overall market.
e. a return equivalent to the level of risk assumed.
2. Which of the following statements best describes what
would be expected to happen as you randomly add stocks
to your portfolio? 7. You have developed the following data on three stocks:

a. Adding more stocks to your portfolio reduces the Stock Standard Deviation Beta
portfolio’s company-specific risk. A 0.15 0.79
b. Adding more stocks to your portfolio reduces the beta B 0.25 0.61
of your portfolio. C 0.20 1.29
c. Adding more stocks to your portfolio increases the
portfolio’s expected return. If you are a risk minimizer, you should choose Stock
d. Statements a and c are correct. if it is to be held in isolation and Stock if it is to be
e. All of the statements above are correct. held as part of a well-diversified portfolio.
 a. A; A 13. Assume that the risk-free rate is 5 percent and that the
b. A; B market risk premium is 7 percent. If a stock has a
c. B; A required rate of return of 13.75 percent, what is its beta?
d. C; A
e. C; B a. 1.25
b. 1.35
8. In a portfolio of three different stocks, which of the c. 1.37
following could not be true? d. 1.60
e. 1.96
a. The riskiness of the portfolio is less than the
riskiness of each of the stocks if each were held 14. An investor is forming a portfolio by investing $50,000 in
in isolation. stock A that has a beta of 1.50, and $25,000 in stock B
b. The riskiness of the portfolio is greater than the that has a beta of 0.90. The return on the market is equal
riskiness of one or two of the stocks. to 6 percent and Treasury bonds have a yield of 4
c. The beta of the portfolio is less than the beta of percent. What is the required rate of return on the
each of the individual stocks. investor’s portfolio?
d. The beta of the portfolio is greater than the beta
of one or two of the individual stocks’ betas. a. 6.6%
e. None of the above (that is, they all could be true, b. 6.8%
but not necessarily at the same time). c. 5.8%
d. 7.0%
9. Which one of the following is an example of systematic e. 7.5%
risk?
A. investors panic causing security prices around the 15. You hold a diversified portfolio consisting of a $10,000
globe to fall precipitously investment in each of 20 different common stocks (that is,
B. a flood washes away a firm's warehouse your total investment is $200,000). The portfolio beta is
C. a city imposes an additional one percent sales tax on equal to 1.2. You have decided to sell one of your stocks
all products that has a beta equal to 0.7 for $10,000. You plan to use
D. a toymaker has to recall its top-selling toy the proceeds to purchase another stock that has a beta
E. corn prices increase due to increased demand for equal to 1.4. What will be the beta of the new portfolio?
alternative fuels
a. 1.165
b. 1.235
10. Inflation, recession, and high interest rates are economic c. 1.250
events that are characterized as d. 1.284
e. 1.333
a. Company-specific risk that can be diversified
away.
b. Market risk.
c. Systematic risk that can be diversified away.
d. Diversifiable risk.
e. Unsystematic risk that can be diversified away.

11. The risk-free rate of interest, kRF, is 6 percent. The

overall stock market has an expected return of 12 percent.
Hazlett, Inc. has a beta of 1.2. What is the required return
of Hazlett, Inc. stock?
a. 12.0%
b. 12.2%
c. 12.8%
d. 13.2%
e. 13.5%

12. A stock has an expected return of 12.25 percent. The

beta of the stock is 1.15 and the risk-free rate is 5 percent.
What is the market risk premium?
a. 1.30%
b. 6.50%
c. 15.00%
d. 6.30%
e. 7.25%