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Lecture Managerial finance - Chapter 16: Capital structure decisions: The basics

Chapter 16 - Capital structure decisions: The basics. This chapter presents the following content: Overview and preview of capital structure effects; business versus financial risk; the impact of debt on returns; capital structure theory, evidence, and implications for managers; example: choosing the optimal structure. | Chapter 16 Capital Structure Decisions: The Basics Topics in Chapter Overview and preview of capital structure effects Business versus financial risk The impact of debt on returns Capital structure theory, evidence, and implications for managers Example: Choosing the optimal structure The Effect of Additional Debt on WACC Debtholders have a prior claim on cash flows relative to stockholders. Debtholders’ “fixed” claim increases risk of stockholders’ “residual” claim. Cost of stock, rs, goes up. Firm’s can deduct interest expenses. Reduces the taxes paid Frees up more cash for payments to investors Reduces after-tax cost of debt (Continued ) The Effect on WACC (Continued) Debt increases risk of bankruptcy Causes pre-tax cost of debt, rd, to increase Adding debt increase percent of firm financed with low-cost debt (wd) and decreases percent financed with high-cost equity (wce) Net effect on WACC = uncertain. (Continued ) The Effect of Additional Debt on FCF Additional debt | Chapter 16 Capital Structure Decisions: The Basics Topics in Chapter Overview and preview of capital structure effects Business versus financial risk The impact of debt on returns Capital structure theory, evidence, and implications for managers Example: Choosing the optimal structure The Effect of Additional Debt on WACC Debtholders have a prior claim on cash flows relative to stockholders. Debtholders’ “fixed” claim increases risk of stockholders’ “residual” claim. Cost of stock, rs, goes up. Firm’s can deduct interest expenses. Reduces the taxes paid Frees up more cash for payments to investors Reduces after-tax cost of debt (Continued ) The Effect on WACC (Continued) Debt increases risk of bankruptcy Causes pre-tax cost of debt, rd, to increase Adding debt increase percent of firm financed with low-cost debt (wd) and decreases percent financed with high-cost equity (wce) Net effect on WACC = uncertain. (Continued ) The Effect of Additional Debt on FCF Additional debt increases the probability of bankruptcy. Direct costs: Legal fees, “fire” sales, etc. Indirect costs: Lost customers, reduction in productivity of managers and line workers, reduction in credit (i.e., accounts payable) offered by suppliers (Continued ) Asymmetric Information and Signaling Managers know the firm’s future prospects better than investors. Managers would not issue additional equity if they thought the current stock price was less than the true value of the stock (given their inside information). Hence, investors often perceive an additional issuance of stock as a negative signal, and the stock price falls. Factors That Influence Business Risk Uncertainty about demand (unit sales). Uncertainty about output prices. Uncertainty about input costs. Product and other types of liability. Degree of operating leverage (DOL). What is operating leverage, and how does it affect a firm’s business risk? Operating leverage is the change in EBIT caused by a change in quantity