EBITDA = Gross Profit

EBIT = Operating Income

Earnings after Taxes/Interest = Net Income
Strengths and Weaknesses of Evaluation Techniques
An evaluation techniue shoul! consi!er
"A# All future incremental pro$ect cash flo%s
"B# The time value of mone&
"'# (ncertaint& associate! %ith future cash flo%s
Pa&)ac* Perio! + + +
,trengths
Eas& to use
(seful if firm is short on cash
(seful in high ris* situations %here either assets rapi!l& )ecome o)solete
or in!ustr& is ver& competitive
-ea*nesses
Emphasi.es liui!it& over profita)ilit&
Ignores cash flo%s occurring after the pa&)ac* perio!
Ignores ris* associate! %ith cash flo%s "Discounte! Pa&)ac*#
Net Present /alue "A# "B# "'#
,trengths
NP/s are a!!itive "sum of NP/ of in!ivi!ual pro$ects = NP/ of 0irm#
Assumes cash flo%s are reinveste! at the hur!le rate
-ea*nesses
Not expresse! as a percentage "Profita)ilit& In!ex#
Doesn1t consi!er the scale of pro$ects
Doesn1t consi!er the life of the pro$ect
Internal 2ate of 2eturn "A# "B# "'#
,trengths
In!icates %hether an investment increases a firm1s value
-ea*nesses
Assumes cash flo%s are re+investe! at I22
3ultiple I22s ma& exist if there are positive an! negative cash flo%s
3a& not give value maximi.ing !ecision if comparing mutuall& exclusive
pro$ects or %hen un!er capital rationing4
3o!ifie! I22 "3o!if& reinvestment rate#
'ompoun! for%ar! all cash inflows at the reinvestment rate
Discount )ac* all cash outflows at the opportunit& cost of capital
,olve for rate that euali.es 0/ of cash inflo%s %ith P/ of cash outflo%s4
3I22 = 5 " 0/ of Inflo%s# / "P/ of Outflo%s# 6 7 "8/9ol!ing Perio!# : 8
Project Cash Flow Analysis
,tep 8; Estimate incremental cash flo%s
I'0 = 50irm 'ash 0lo%s %ith Pro$ect6 : 50irm 'ash 0lo%s %/o Pro$ect6
Inclu!e effects of taxes/inflation
Exclu!e overhea! expenses that aren1t affecte! )& the pro$ect
Transfer pricing %ithin a firm "(se mar*et prices#
Exclu!e all financing costs< even if pro$ect is partiall& finance! %ith !e)t
,eparate the investment an! financing !ecision
Treat pro$ect as if it %ere all+euit& finance!
'oncerne! %ith onl& operating flo%s< not financing "out#flo%s
,tep =; Estimate the Net Initial Investment
'ost of acuiring an! installing the necessar& assets
Net procee!s from the sale of existing assets
Tax effects associate! %ith the sale of existing assets an! their replacement
,tage! in Investment
,tate initial outla& in present value terms
'onseuences
2e!uces the P/ of initial cost
Dela&s the receipt of pro$ect cash inflo%s
T&picall& re!uces the pro$ect1s NP/
,tep >; Estimating Operating 'ash 0lo%s
Bottom+(p
O'0 = EBIT : Taxes ? Depreciation
Top+Do%n
O'0 = EBITDA : Taxes
Tax ,hiel!
O'0 = EBITDA@"8+ # ? Depreciation@
Onl& use income an! expenses from operations in calculating EBIT an! EBITDA
Operating Aeases
'harge! to rental over lease term %ith no asset or lia)ilit& recor!e! on
)alance sheet4
Aeases as 'apital leases if;
The life of the lease is at least BCD of the asset1s life< or
The o%nership of the asset is transferre! to the lessee at the en! of the life
of the lease< or
There is a EBargain purchaseF option %here)& the purchase price is )elo%
the expecte! mar*et value< or
The present value of the lease pa&ments excee!s GHD of the initial value
of the asset4
If not< the lease is treate! as an operating lease4
De)t /alue of Operating Aeases = P/ of pa&ments using pre+tax 'ost of De)t
EBIT ? 5Pre+tax 'ost of De)t @ De)t /alue6 = A!$uste! EBIT
Intuition; Operating lease pa&ments are treate! as an or!inar& operating
expense even though it is a financing cost analogous to interest< so %e a!!
it )ac*4
,tep I; Estimating the Terminal /alue
,alvage /alue : Boo* /alue = Taxa)le Gain
,alvage /alue : Taxes@Taxa)le Gain = After+tax Terminal /alue
,tep C; Estimating the Incremental 0'00
'ash flo% availa)le to all investors in the firm< after pa&ing taxes an! meeting
an& net investment nee!sJ it is pre+!e)t< )ut after+tax4
Operating 'ash 0lo%
+ Net -or*ing 'apital "An increase = 'ash Outflo%#
+ 'apital Expen!itures
After+tax 0'00
Net -or*ing 'apital = 'urrent assets : 'urrent lia)ilities
2euire! to cover expenses that arise< initial inventories< etc4
Exclu!e !e)t< excess cash
T&picall& all recovere! at en! of pro$ect life
'apital Expen!itures = Net initial investment
Treate! as 'apital outla&s< not expenses
'apitali.e!< an! !epreciate! over time4
5'hange in N-' ? 'apital Expen!itures6 = Net Investment nee!e! to generate
O'0
0'00 = EBIT +or+ 0'0E
?Depreciation ?Interest Expense@"8+#
+'apital Expen!itures ?Principal 2epa&ments
+-or*ing 'apital +Ne% De)t Issues
?Preferre! Divi!en!s
Types of Cash Flows to the Fir
3aximi.e value to the firm< not value to the euit& hol!ers
EBITDA %hen 'apEx = H< -' = -' = H
Discount 2ate Before Tax -A''
EBIT@"8+# %hen 'apEx = H
Discount 2ate After Tax -A''
Net Income@"8+# %hen 'apEx=Depreciation
Non+Operating !on1t recur
Discount 2ate After Tax -A''
0'00 %hen 'apEx?-' = Expenses for Gro%th
Discount 2ate After Tax -A''
E/A"Econ Profit# %hen 0inance 'osts are treate! as Expenses
Discount 2ate After Tax -A''
Types of Cash Flows to Equity
Divi!en!s "DP,# %hen DP, = 0'0E< 0'0E har! to estimate
",toc* repurchases are treate! as !ivi!en!s#
Discount rate 'ost of Euit&
Earnings %hen DP, = EP,< or 2OE = 'ost of Euit&
Discount rate 'ost of Euit&
0'0E %hen DP, K 0'0E< DP, L MHD0'0E< DP,
(navaila)le
Discount rate 'ost of Euit&
(se Euit& /aluation;
0or firms %ith sta)le leverage
If euit& is )eing value!
(se 0irm /aluation;
0or firms %ith too high/lo% leverage an! expect to change over time4
0or firms having onl& partial information on !e)t
If valuing the firm rather than the euit&
(se Nominal 0lo%s;
If inflation is lo% "Taxes are )ase! on nominal income#
If using nominal !iscount rate
(se 2eal 0lo%s
If using real !iscount rate
0'0E ; Operating 'ash 0lo% : 'ash Expenses Nee!e! for Gro%th
Pure Euit& 0irm
0'0E = Net Income
?Depreciation
+'apital Expen!itures
+-'
Aevere! 0irm "De)t< Euit&< preferre! Euit&#
0'0E= Net Income
?Depreciation
+Principal 2epa&ment of De)t
+Preferre! Divi!en!s
?Procee!s from Ne% De)t N Preferre! offerings
+'apital Expen!itures
+-'
,ta)le Aeverage "0inancing !one at a fixe! !e)t ratio " De)t / 5De)t?Euit&6 #
0'0E= Net Income
+"8+#@"'apital Expen!itures : Depreciation#
+"8+#@-or*ing 'apital
"see page 130)
Impact of Inflation
Nominal 'ash 0lo%s an! Nominal Discount 2ate
Incorporate expecte! inflation into future cash flo% estimates an! the
!iscount rate
+or+
2eal 'ash 0lo%s an! 2eal Discount 2ate
Estimate cash flo%s in real !ollars an! !iscount at a real !iscount rate
2eal 'ash 0lo%t= Nominal 'ash 0lo%t / 5 8 ? Expecte! Inflation 2ate#
t
8 ? 2eal Discount 2ate = 58 ? Nominal 2ate6 / 58 ? Expecte! Inflation 2ate6
(see pages 113, 137: Inflation affects sales, cost savings, WC)
Project Analysis and Evaluation! Addressing "isk "page 8I>#
2is*; 9o% much uncertaint& exists< the !egree of uncertaint&
Drivers of (ncertaint&
Economic 'on!itions 3ar*et 'on!itions
Taxes Interest 2ates "cost of raising future capital#
International 'on!itions
2euire! 2ate of 2eturn = 'ompensation for Time ? 'ompensation for 2is*
(see page 150, standard deviation)
'oefficient of /ariation = ,tan!ar! Deviation / Expecte! /alue
(nit of 2is* per (nit of /alue
3easuring a Pro$ect1s 3ar*et 2is*
8# Pro$ect 2is* = 3ar*et 2is*
-hen the firm is in one line of )usiness
-hen the firm ta*es on similar pro$ects
A!vantage; Doesn1t reuire ris* estimation for each pro$ect
Aimitation; 3a& not appl& to firms in multiple lines of )usiness
=# Pure Pla& Approach
-hen there are pu)licl& tra!e! firms in the same line of )usiness
3etho!; I!entif& )usiness of each !ivision or pro$ect
I!entif& pu)lic firms involve! primaril& in the )usiness
O)tain mar*et ris* parameters for these compara)les
'orrect mar*et ris* for financial leverage
Estimate cost of euit& for the !ivision or pro$ect
BA = B( @ " 8?"8+#@D/E #
(se mar*et values of De)t/Euit&
># Accounting Betas< 2egress earnings
Pitfalls; ,moothe! )etas< non+operating factors< EP, is once uarterl&
2egress EP, of mar*et %ith EP, of ,PCHH
Treat ,lope as )eta
I# Beta from 'ross+sectional regressions
'/ in Operating Income
De)t/Euit& 2atio
Earning Gro%th
Total Assets
2egress !ata %ith compara)les4
'ommon errors
0ailure to consi!er ris*
Dou)le counting the same ris* using more than one ris* a!$ustment
Appl&ing an incorrect ris* profile
'onsi!ering E!iversifia)leF ris* in anal&sis
#ncorporating Project "isk
2is* A!$uste! 2ates
/alue = 52is*& 'ash 0lo%st / "8 ? 2is* A!$uste! 2ate#
t
6
2is* A!$uste! 2ate = 2f ? "2m + 2f#
3etho!; Discount 'ash 0lo%s using 2is* A!$uste! 2ate
,um for NP/
'ertaint& euivalents
/alue = 5'ertaint& Euivalent 'ash 0lo%st / " 8?2f #6
'E 'ash 0lo%t = 2is*& 'ash 0lo%t 5 "8?2f# / "8?2is* A!$uste! 2ate # 6
t = "8?rf#
t
/ "8?*e#
t
3etho!; Discount 'ash flo%s using 2is* A!$uste! 2ate
+an!+
3o!if& "multipl&# )& 2is* 0ree 2ate
2esulting 'ash 0lo%s are 'ertaint& Euivalents
Discount 'E 'ash 0lo%s using 2is* 0ree 2ate
,um for NP/
Oualitative Assessment
Porter1s 0ive 0orces
Threat of Ne% Entrants< Threat of ,u)stitutes<
,upplier1s Bargaining Po%er< Bu&er1s Bargaining Po%er<
Existing 'ompetitors4
Oualitative Assessment
,cenario Anal&sis : 3ultiple factors var&ing in small !egrees
,ensitivit& Anal&sis : ,ingle factor var&ing in large !egrees
,imulation Anal&sis : 'alculate mean/st!ev/!istri)ution of NP/s
0ocus on assumptions that matter the most< those un!er management control<
those %ith most uncertaint&4
Accounting Brea*even
2evenues = 'osts
Accounting Profit = H
I22 = +8HHD "Initial Investment completel& lost#
0inancial Brea*even
P/ of Benefits = P/ of 'osts
NP/ = H
I22 = 9ur!le 2ate
0inancial 0orecasting
Pro 0orma 0inancial ,tatements; Pre!iction of %hat a firm1s financial statements
%ill resem)le at the en! of the forecast perio!
(, Implie! 2is* Premium
'onstant Gro%th 3o!el
5 D / P ? g 6
,u)tract out the 2is* 0ree 2ate
5 D/P ? g 6 + 2f = " 2m+2f #
D = Divi!en!s on the ,NPCHH
P = 'urrent level of ,NPCHH
g = Expecte! gro%th rate of ,NPCHH
2f = 2ate on 8H &ear T+Bon!
Assumes; 2ight mo!el is use!
3ar*et is correctl& price!
Inputs are correct
Estiating $eta of a Fir
0irm = %8,u)si!iar&8 ? %=,u)sis!iar&= 444
%i = 3ar*et /alue of ith !ivision / mar*et value of firm1s euit&
Estimate )eta of ,u)si!iaries using compara)les
'ost of Euit&
Term ,tructure of Interest 2ates
?2eal 2ate
?Inflation Premium
?3aturit& Premium
2is* Premium
?,&stematic 2is*
2is* of Pro!uct Divisions
De)t/Euit& "Aeverage#
?3ar*et Premium
Term ,tructure of Interest 2ates "On the run treasuries#
2eal 2ate : 0lat
Inflation Premium : 'onstant increase
Interest 2ate 2is* Premium + Aogarithmic
Weighted Average Cost of Capital
'ost of 'apital; 2euire! return !eman!e! )& each class of claim hol!ers<
%eighte! )& their proportionate share of financing that the& provi!e to the firm4
(se! to !iscount cash flo%s to the firm
Thin* in terms of target capital structure
2evie% management1s approach to financing the )usiness
An! it1s implications for the target capital structure
Aong Term or ,hort TermP
3an& )orro%ers use short+term !e)t that the& !on1t repa&4
Is short term !e)t vie%e! as permanent or transitor& "%or*ing capital#P
De)t to Inclu!e
,hort term portion of long term !e)t
Boo* value Q 3ar*et value
Assume *,T De)t = *AT De)t if !e)t is rolle! over
'onverti)le De)t
Is the call option in or out of the mone&P
Treat as straight !e)t if far out of the mone&
Aong term !e)t
(se mar*et value if uotes are availa)le
If uotes !on1t exist< !iscount pa&ments using rate of compara)le
securities
Off Balance sheet lease o)ligations
'apital Aeases "Inclu!e#
Operating Aeases "Exclu!e#
Off Balance sheet transactions
In!emnification of a su)si!iar&1s !e)t
Euit& to Inclu!e
Preferre! stoc*
Divi!en! &iel! for EstraightF preferre!
Option pricing mo!el for calla)le / converti)le preferre!
Deferre! income tax
Ouasi+euit&< fun!s )elong to sharehol!ers until pai!
'onservative approach; consi!er onl& the permanent !eferral
3inorit& Interest
Ouasi+euit&; >
r!
part& o%ns a percentage of one or more of the
firm1s su)si!iaries
Inclu!e if -A'' is )ase! on )oo* value
'ommon ,toc*
(se )oo* value if calculating -A'' using )oo* values
If no price per share "mar*et value#< use relative value approach< or
!iscounte! cash flo% approach4
-A'' = %!@*! ? %e@*e
E/A "Economic Profit#
Difference )et%een revenues an! costs< %here costs inclu!e expenses an! the cost
of capital4
'osts = Expenses ? 'ost of 'apital ? -A''@Assets
Approximation
EBIT@"8+#
+-A''@Total 'apital
Economic Profit
Total 'apital = Boo* /alue of ,hort/Aong Term De)t ? B/ of Euit&
E/A = "2OI' : -A''#@Investe! 'apital
2OI' = EBIT"8+# / Investe! 'apital
0ormal Approach
,ales
?Implie! Interest expense on Operating Aeases
?Increase in AI0O reserves
?Other income
+'oG,
+,GA
+Depreciation
A!$uste! Operating Profit after tax
+'ash operating taxes
Net Op4 Profit After Tax
%aluation
Discounte! 'ash 0lo%; The value of an asset is the present %orth of future
anticipate! cash flo%s
2elative valuation; The value of an asset is )ase! on compara)les
'ontingent claim valuation; Option pricing mo!els are use! to value assets %ith
em)e!!e! option characteristics
Dealing %ith 'ash an! 3ar*eta)le ,ecurities
'ash flo%s shoul! )e )efore interest income from 'ash an! euivalents
The !iscount rate shoul! not )e contaminate! )& inclu!ing cash
Expecte! Gro%th 2ate = 2einvestment 2ate @ 2eturn on 'apital
Terminal /alue = 0'00T?8 / "r+gT#
(see page 321)
Divi!en!s
Appl& gro%th to !ivi!en!s for *no%n &ears T
Determine Terminal /alue at &ear T?8
Discount )ac* "0or Terminal /alue< use same P/ 0actor as &ear T#
,um P/ for Total /alue
%aluation &odels! 'eneric For
'ase 8; ,ta)le Gro%th
Price = Expecte! 'ash 0lo% / 5Discount 2ate : Gro%th 2ate6
(se to estimate terminal value "sta)le gro%th perio!#
Assumptions;
'ash 0lo%s are gro%ing at a sta)le gro%th rate that1s close to the
econom&1s gro%th rate
'ase =; T%o ,tage Gro%th (see page 323)
'hoosing an appropriate gro%th mo!el;
(se a > stage gro%th mo!el if &our firm is;
,mall an! gro%ing at a high rate
9as significant )arriers to entr&
9as firm characteristics !ifferent from the norm
(se a = stage gro%th mo!el if &our firm is;
Aarge an! gro%ing mo!eratel&
9as a single pro!uct %ith )arriers to entr& %ith a finite life
(se a sta)le gro%th mo!el if &our firm;
Is large an! onl& gro%ing at a lo% rate
9as characteristics of a sta)le firm e4g4 average ris* an! reinvestment rates
Du Pont 3o!el
-hen Past Gro%th is not an in!icator;
0un!amental change in the pro!uct line
0un!amental change in manufacturing or sales polic&
'hange in 3anagement
Aoss of a special a!vantage
Estimation of 0irm Gro%th; Aeverage
gEuit& = gEP, = 58 : DP,/EP,6@2OE =
58 : DP,/EP,6@52OA?"B/ De)t/B/ Euit&#@"2OA+i"8+##6
2OA = EBIT"8+# / B/ of 'apital
g0irm = gEBIT = 5"'apEx : Depreciation ? -'# / EBIT"8+#6@"EBIT"8+# / Assets
g0irm = gEBIT = "'apEx : Depreciation ? -'# / Total Assets
Gro%th to%ar!s ,ta)le 0irms< 3ean 2eversion
Beta shoul! move to%ar!s = 8
'ost of !e)t shoul! reflect the safet& of sta)le firms
De)t 2atio shoul! move to optimal/in!ustr& average
2einvestment rate shoul! reflect the expecte! gro%th rate an! return on capital
2einvestment 2ate = Expecte! Gro%th 2ate / 2eturn on 'apital
2elationship of Economic Profit to 0irm /aluation
3/A = 3ar*et /alue : 'apital = NP/0irm = NP/Pro$ect = 5E/A/"8?-A''#
t
6
= ,um "0or all Pro$ects# of E/As !iscounte! using -A''
3/A ? 'apital = 3ar*et /alue
(see page 35)
0'00 an! E/A /aluation shoul! result in similar values
Both reuire the same information; expecte! cash flo%s an! -A''
E/A
E/A is closel& relate! to NP/< 0irm value increases if the firm invests in positive
NP/ pro$ects
E/A is useful for measuring management performance
3anagers have control over E/A< unli*e stoc* prices
Profits !on1t increase value per se if the& !on1t represent a return on the investe!
capital that1s greater than the cost of capital
Anal&.ing Negative 2eturns
a Temporar& Pro)lems
a '&clicalit&
a Normali.e Earnings
) ,tructural Pro)lems
Target operating margins of sta)le firms in the sector
) Aeverage Pro)lems
Target average/optimal !e)t ratio the firm is comforta)le %ith
) Aong Term Operating Pro)lems
Target in!ustr& average operating margins
) /alue the firm using !etaile! cash flo% forecasts an! re!uce/eliminate
the pro)lem over time
/alue of 0irm = 0'00TT3"8?gEBIT# / "-A'' + gEBIT#
Financing (ecision! Capital Structure
0inancial ,tructure; 3ix of all items that appear on the right+han! si!e of the firm1s
)alance sheet4
'apital ,tructure; 3ix of the long+term sources of fun!s use! )& the firm
-hen De)t 0inancing is use!;
,harehol!ers must pa& cre!itors the interest on !e)t
Earnings are the resi!ual claim after interest an! taxes are pai!
The greater the !e)t amount use!< the greater the s%ing in earnings
Benefits of leverage; 2eturn on assets vs4 cost of !e)t
-hen Euit& 0inancing is use! exclusivel&
Ol! sharehol!ers share the earnings %ith ne%/a!!itional sharehol!ers
Original o%ner1s return on euit& an! earnings per share is !ilute!
Operating Aeverage
The use of fixe! operating costs in the operating structure
if; DEBIT / D,ales K 8
The greater the !egree of operating leverage< the more profits var& %ith a given
percentage change in sales
0inancial Aeverage
The use of fiexe! financing cost in the capital structure
if; DEP,/DEBIT K 8
'om)ine! Aeverage
DOA@D0A = DEP,/D,ales = Degree of 'om)ine! Aeverage
'om)ine! leverage is the total ris* exposure a firm assumes can )e manage! )&
com)ining operating an! financial leverage in !ifferent !egrees4
&odigliani and &iller
'apital mar*ets are frictionless
In!ivi!uals can )orro% an! len! at the ris*less rate
There are no costs from )an*ruptc&
0irms can onl& issue ris*less !e)t or euit&
All firms are assume! to )e in the same ris* class
No personal taxes
All cash flo%s are perpetuities
'orporate insi!ers an! outsi!ers have the same information
3anagers al%a&s maximi.e sharehol!er %ealth
/alue of a firm in 3N3
/alue
A
= 5 EBIT"8+# / *e
u
6

? iD

/ *! = /
(
? "P/ of De)t#

-ith no corporate taxes;

/alue of firm is in!epen!ent of its capital structure
-hen c = H < /
A
= /
(
Average cost of capital is in!epen!ent of its capital structure
/alue !epen!s on the firm1s earnings< no on ho% earnings are split )et%een
sharehol!ers an! cre!itors4
Because; No matter ho% &ou slice up claims to the firm1s earnings< it is still the
same firm %ith the same earning po%er an! thus< the same mar*et value4
Benefits of increase! sharehol!er returns from higher leverage are offset )&
increase! ris*s so mar*et value is unaffecte! )& leverage4
-ith corporate taxes;
/alue of the levere! firm euals the value of the unlevere! firm plus the
present value of the !e)t tax shiel!4
Average cost of capital !eclines as more !e)t is use!
'ash flo% to the firm increases %ith leverage )& the amount of the tax shiel!4
(see page 11)
De)t1s Tax A!vantage
Interest pai! on !e)t is tax !e!ucti)le
Divi!en!s suffer from !ou)le taxation
P/ of Interest Tax ,avings = 3arginal Tax 2ate @ De)t
Assumes; De)t is permanent "rolle! over#
Discount rate is interest rate
Expecte! tax rate remains constant
-h& not use 8HHD De)t 0inancingP
'an1t use interest tax shiel!s )ecause incurring or a)out to incur losses
Ban*ruptc& costs
Agenc& costs
Information costs
Aoss of future financial flexi)ilit&
As more !e)t financing is use!< pro)a)ilit& of financial !istress an! )an*ruptc& increase
)ecause fixe! o)ligations increase
P/ of the cost of financial !istress
Increases in )usiness ris*
Increases in financial ris*
Aimite! lia)ilit&; incentive to use !e)t for ris*& pro$ects
Degree that a firms value !epen!s on intangi)le assets
'omponents of Business 2is*
,ensitivit& of firm1s pro!uct !eman! to general economic con!itions
If GNP !eclines< !oes the firm1s sales level !ecline )& a greater DP
Degree of competition
Is the firm1s mar*et share small in comparison %ith other firms that
pro!uce an! !istri)ute the same pro!uctP
Pro!uct !iversification
Is a large proportion of the firm1s sales revenue !erive! from a single
ma$or pro!uct or pro!uct lineP
Operating leverage
Does the firm utili.e a high level of operating leverage resulting in a high
level of fixe! costsP

/ ,
?

, ,
?
Business 2is* = EBIT / EBIT
"'ovariance#
" EBIT+Int # / EBIT Q 'ompare to Business 2is*4 9o% much )reathing room is thereP
Agenc& 'osts
,toc*hol!er : 3anager 'onflicts
3anagement1s ten!enc& to consume firm resources
3anager ten!enc& to shir* responsi)ilities as their euit& falls
,toc*hol!er : Bon!hol!er 'onflicts
3anagers can create sharehol!er %ealth& either )& increasing firm value
or )& re!ucing the value of its )on!s4
9igh leverage +K Bon!hol!ers )ear most of the ris*< )ut sharehol!ers get
most of the potential re%ar!s !ue to limite! lia)ilit&4
De)t as One ,olution to Agenc& 'osts of Euit&
Aeverage! 2ecapitali.ations; 0irm increases its !e)t an! re!uces its euit&
Aeverage! cash+outs ; A t&pe of Aeverage! 2ecapitali.ations in %hich
management an! emplo&ee stoc* plans receive ne% shares of roughl&
euivalent value rather than cash for the ol! shares
Aeverage! Bu&outs ; A small group of investors )u&s the firm an! ta*es it
private using mostl& )orro%e! fun!s secure! )& the firm1s assets
Esta)lishing a 'apital ,tructure
The optimal !e)t ratio tra!es off the interest tax shiel! )enefit against the costs of
financial !istress an! agenc& costs4
Incremental s are eual at A@ "Optimal !e)t ratio#
/alue of an All Euit& 0irm
? /alue of the Interest Tax ,hiel!
+ P/ 'osts of 0inancial Distress
+ P/ of Agenc& 'osts
/alue of the 0irm
0inancial 0lexi)ilit& 0avors Euit& 0inancing
0inancial 0lexi)ilit&; The concern that to!a&1s !ecision !oesn1t $eopar!i.e future
financing options
'onsi!erations
0irm1s gro%th potential
0irm1s access to capital mar*ets
/olatilit& of firm1s earnings
'overage / other leverage ratios
3ar*et ,ignaling as an Argument Against Euit& 0inancing
Asuith an! 3ullins; Over MHD of in!ustrial firms %ho announce! a ne% euit&
sale ha! a !ecline in stoc* price on the !ate of the announcement4 "Dilution#
Announcement of a firm1s intention to repurchase shares lea!s to an increase in
stoc* price
De)t announcements haven1t cause! significant a!verse price changes
-h& (se Internal Euit& 0inancing 0irstP
Issue cost for ne% euit& an! !e)t
Ne% euit& ; C+8HD of the amount raise!
De)t ; =4C : CD of the amount raise!
2etaine! profits an! ne% )orro%ing have )een sufficient
3anagers have a fixation for EP,; Does financing !ilute EP,P
Internal financing !oesn1t lea! to !ilution of EP,
De)t financing t&picall& increases EP,
Ne% Euit& issues t&picall& !ecrease EP,
,toc* mar*et is an unrelia)le fun!ing source
,ustaina)le Gro%th; maximum rate at %hich compan& sales can increase %ithout
!epleting financial resources
0ast Gro%th 'ompan&< Actual Gro%th"gA# K ,ustaina)le Gro%th"g,#
Borro% cash if onl& a short term pro)lem
,ell ne% euit&
Increase leverage
2e!uce !ivi!en! pa&out ratio
Profita)le pruning; sell off marginal operations an! plo% mone& )ac*
Out sourcing
Increase prices
3erger
3oral; Gro%th isn1t necessaril& something to maximi.e
,lo% Gro%th 'ompan&< Actual Gro%th"gA# L ,ustaina)le Gro%th"g,#
'ontinue to accumulate resources if short term pro)lem
Internal gro%th via 2ND an! organi.ational change
Increase !ivi!en!s
2epurchase shares
Bu& gro%th; !iversif& into other )usiness
0inancing !ecision is place! %ithin the larger context of managing gro%th
Develop !ivi!en!< financing< an! gro%th strategies that ena)le firm to expan! at the
!esire! rate %ithout resorting to issuing ne% stoc*
(sing DuPont 3o!el to 'alculate ,ustaina)le Gro%th (see page 0)
3aintain a conservative leverage ratio =K ensures continuous mar*et access
A!opt a mo!est !ivi!en! polic& =K ena)les gro%th via internal financing
(se cash< mar*eta)le securities< an! unuse! )orro%ing capacit& as liui!it& )uffers
If external financing is necessar&< raise !e)t unless resulting leverage ratio is too high
,ell euit& or re!uce gro%th onl& as a last resort
2etaine! Earnings 0inancing
A!vantages
Avoi!s )ringing in outsi!ers
Avoi!s !ou)le taxation on firm1s profits
Avoi!s costs of ne% stoc* issue
Avoi!s !ilution of control
Direct su)stitute for commons toc* financing
Disa!vantages
'ome at expense of !ivi!en!s an! share repurchases
(nrelia)le source unless earnings are sta)le
Incentive to invest in lo% return pro$ects "no monitoring#
De)t 0inancing
A!vantages
Tax !e!ucti)le
Pa&ments are limite! "No share in value creation#
Bon!hol!ers !on1t vote
Gives stoc*hol!ers a Eput optionF
Issue costs lo%er than stoc*
Disa!vantages
Increases financial ris*
Increases cost of euit& capital
'onvenants ma& limit a)ilit&
'aveats
/aries inversel& %ith inflation
Preferre! ,toc* 0inancing
A!vantages
0avora)le 0inancial leverage
0lexi)ilit& in managing cash flo% : can omit !ivi!en!s
'ontrol of firm isn1t !ilute!
Disa!vantages
Divi!en!s aren1t tax !e!ucti)le
9ave priorit& over common stoc*hol!ers1 claims
0ailure to meet preferre! !ivi!en!s coul! force granting of voting rights
'ommon ,toc* 0inancing
A!vantages
Not reuire! to pa& !ivi!en!
No o)ligation to re!eem common stoc*
Disa!vantages
Diluting control of existing o%ners
Dilution of earnings
9igher cost
2everse Engineering the 'apital ,tructure
,elect the )on! rating the firm %ants
-or* )ac*%ar!s to estimate the maximum amount of !e)t consistent %ith the
chosen rating