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Corporate Finance

Corporate Finance. Lecture 7. Topics covered. Weighted Average Cost of Capital Long term financing with equity. Equity. Debt. r WACC =. × r Equity +. × r Debt × (1 – T C ). Equity + Debt. Equity + Debt. S. B. r WACC =. × r S +. × r B × (1 – T C ). S + B. S + B.

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Corporate Finance

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  1. Corporate Finance Lecture 7

  2. Topics covered • Weighted Average Cost of Capital • Long term financing with equity

  3. Equity Debt rWACC = × rEquity + × rDebt ×(1 – TC) Equity + Debt Equity + Debt S B rWACC = × rS + × rB ×(1 – TC) S + B S + B Extention of the basic model • The Weighted Average Cost of Capital • It is because interest expense is tax-deductible that we multiply the last term by (1 – TC)

  4. WACC • Example: a firms with a debt-equity ratio of 0.6, a cost of debt of 15.15%, and a cost of equity of 20%. The corporate tax rate is 34%. • Debt to value ratio=6/(10+6)=0.375 • Equity to value ratio=1-0.375=0.625 • rwacc=0.625*20%+0.375*15.15%*(1-0.34) =16.25%

  5. Steps to calculate WACC Cost of equity by using CAPM Cost of debt by calculating yield to maturity of the debt Calculate WACC

  6. Difference between debt and equity

  7. Long-term financing: Common stock • Directly contributed capital • Par value • Shares authorized vs. Shares issued • Dedicated capital • Capital surplus • Indirectly contributed capital • Retained earnings • Book value • Market value

  8. S S B B Capital structure • What is the goal of the firm: maximizing V or maximizing S? • Firm value V=B+S

  9. Capital structure: max V vs. max S Change in capital structure benefits shareholders only when the firm value increases.

  10. Financial leverage: an example Consider an all-equity firm that is considering going into debt. (Maybe some of the original shareholders want to cash out.) Current Assets $20,000 Debt $0 Equity $20,000 Debt/Equity ratio 0.00 Interest rate n/a Shares outstanding 400 Share price $50 Proposed $20,000 $8,000 $12,000 2/3 8% 240 $50

  11. EPS and ROE Under Current Capital Structure Recession Expected Expansion EBIT $1,000 $2,000 $3,000 Interest 0 0 0 Net income $1,000 $2,000 $3,000 EPS $2.50 $5.00 $7.50 ROA 5% 10% 15% ROE 5% 10% 15% Current Shares Outstanding = 400 shares

  12. EPS and ROE Under Proposed Capital Structure Recession Expected Expansion EBIT $1,000 $2,000 $3,000 Interest 640 640 640 Net income $360 $1,360 $2,360 EPS $1.50 $5.67 $9.83 ROA 5% 10% 15% ROE 3% 11% 20% Proposed Shares Outstanding = 240 shares

  13. EPS and ROE Under Both Capital Structures All-EquityRecession Expected Expansion EBIT $1,000 $2,000 $3,000 Interest 0 0 0 Net income $1,000 $2,000 $3,000 EPS $2.50 $5.00 $7.50 ROA 5% 10% 15% ROE 5% 10% 15% Current Shares Outstanding = 400 shares LeveredRecession Expected Expansion EBIT $1,000 $2,000 $3,000 Interest 640 640 640 Net income $360 $1,360 $2,360 EPS $1.50 $5.67 $9.83 ROA 5% 10% 15% ROE 3% 11% 20% Proposed Shares Outstanding = 240 shares

  14. Financial Leverage and EPS 12.00 Debt 10.00 8.00 No Debt Advantage to debt 6.00 Break-even point EPS 4.00 Disadvantage to debt 2.00 0.00 1,000 2,000 3,000 EBIT in dollars, no taxes (2.00)

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