Chapter 14 – Cost of Capital Chapter 15 – Raising Capital Chapter 16: Financial leverage and structural policy
*RR = 10% - Firms must earn 10% on investment to compensate investors for the use of capital they * venture capital – private financing for relatively new businesses in exchange for stock (high risk) Firm value is maximized when the WACC is minimized *increase leverage by issuing debt and
gave to finance the project *angel investor – wealthy individual who invests in early stage ventures (finance in stages) repurchasing O/S *decrease leverage by issuing new shares& retiring O/S debt
*Cost of capital for Bo = risk free rate *Cost of capital depends on the risk of the investment Stages in development seed -> start up -> expansion -> acquisition -> turnaround debt financing increases the fixed interest exp; leverage amplifies the variation in EPS and ROE
ROE = Net income after income and taxes divided by average shareholders equity *choosing a vc: financial strength; obtain and check references; contacts; compatible mngmt; exit *increased debt can mag ROE when prof is good; can also make EPS and ROE more risky
Cost of equity – return that equity investors require on their investment in the firm strategy Steps for a new issue: Obtain perm from BOD -> prep and dist prelim prospectus -> OSC % 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝐸𝑃𝑆 𝐸𝐵𝐼𝑇
1) Dividend growth model: PV of all future dividends - get the stock price at any point in time, 𝐷𝑒𝑔𝑟𝑒𝑒 𝑜𝑓 𝑓𝑖𝑛𝑎𝑛𝑐𝑖𝑎𝑙 𝑙𝑒𝑣𝑒𝑟𝑎𝑔𝑒: 𝑜𝑟
reviews prelim. -> when approved, price is determined and security dealers can begin selling new issue % 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝐸𝐵𝐼𝑇 𝐸𝐵𝐼𝑇 − 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡
Pros: simple, cons: only applicable if currently paying div; need const growth rate; doesn’t consider When EBIT is expected to increase, lev is beneficial
Public issues: * General cash offering: new securities offered for sale to the general public on a cash
risk; sensitive to est growth rate *variability in both ROE and EPS increases when fin leverage is increased; * BE EBIT: EBIT where EPS is
Constant growth: D1 = Do x (1+g) Cost of equity: Re = (D1/ Po) + g basis *Rights offer: new securities are first offered to existing shareholders; Spread: difference b/w
what the synd pays the company and what the security sells for [compensation: buying price – offering the same under current and proposed capital structure. * EBIT >BEP: lev is ben(High EPS); EBIT <BEP:
×( ) ×( )
𝑃 = 𝑃 = = price] Total cash received (bought deal with spread): Total shares x share price x (1-spread) lev in det. (low EPS) - if EBIT is less than BEP – choose unlev option
Grows at constant rate after some time Dt = Do x (1+g)T Net proceed to company for each share: sub price x (1-spread) EPS in all equity firm = EPS in firm with debt
Po: price/share of stock today Dividend: div/share in 1 year Types of underwriting: *Bought deal (firm commitment): issuer self entire issue to one underwriting EBIT/ # of shares = (EBIT – interest)/ # of shares
k:expected rate of return – discount rate g: growth rate of company (future) General case: price today synd and underwriter makes $ on spread; assume risk of not selling entire issue *Best efforts NI = EBIT – Interest EPS = NI / Shares O/S
of share of stock is the OV of all its future div To find EPS: Share price share price x repurchase total shares NI EPS
underwriting(reg UW): UW makes best effort to sell but doesn’t guarantee to sell the entire issue;
Po = E D/ (1+r)1 + D/(1+r)2 + D/(1+r)3…. Homemade leverage: use of personal borrowing to change the overall amount of fin lev to which the
offer may be pulled if there isn’t enough interest at the offer price *Dutch Auction (Uniform price): not
Estimating growth: g = (1- Payout Ratio)(ROE) individual is exposed.
set fixed price; price is det based on bids in an auction – (price w most shares x # shares) Selling
Earnings next year: earnings this year + RE this year x return on Re Bankruptcy costs *Direct costs: legal, admin – causes additional loses, disincentive to debt financing
Period: when issue is being sold to the public, the synd agrees not to sell securities for less than the
(1-Payout Ratio) = Retention Ratio *Financial distress – prob w meeting debt obligations *Indirect costs – lost sales, interrupted ops and
g = Retention ratio x ROE Retention ratio = Re / net income offering price until synd dissolves UW is permitted to buy shares if the mkt price falls below the
loss of employees b/c mngmt spends time worrying about avoiding bankruptcy than running the
DDM Zero growth rate: constant dividend offering price to stabilize from down pressure if unsold, leave or sell at mkt price. Overallotment
business.
Perpetuity: 𝑃 = (Green shoe provision): UW buy additional shares at the OG price offering and immediately sell them
static theory of cap structure: firm borrows up to point where the tax benefit from an extra $ is debt =
– gives protection for lead UW as they perform their price stabilization function Lock up agreement:
Return on equity = net income after interest and taxes/ avg. common SH equity cost of increased prob of fin stress (WACC in minimized)
specifies how long insiders must wait after an IPO before they can sell stock (180) – if with VC could
2. SML Approach E (Re) – Rf + Be x [E(Rm) – Rf] RR: (Re) = Rf + Be x [Rm – Rf] *tax ben is only important if the firm has a large tax liability
have loss when the VC cashes out. Quiet period: communications are limited to ordinary
Market risk premium: E[Rm] – Rf * Assumes future risks are similar to past risks; applies to firms that *the greater the risk of fin distress, the less debt will be optimal for the firm
announcements (40) – end: favourable buy recommendation
retain all earnings B = beta of stock Rf = risk free rate Rm = Expected mkt return Pecking Order: internal issue debt (inverse rel w profit and debt equity (last resort) [cap st is
Underpricing: P 1st day of SEO – Offer price in IPO (risky: attract)
Expected return – return on any risky asset expected in the future dictated by its need for ext. fin]
SEO: man info, debt usage, issue costs – negative signal
Reduction of Rf will increase a firm’s cost of equity Prop 1: Firm value Prop 2: WACC
*Larger firms can raise equity more easily*cost with underpricing can exceed the direct costs*issue
Cost of debt = YTM – return lenders require on the firm’s debt – NOT the coupon rate (unless face val Case 1 VU = EBIT/ REU = VL = EL + DL Cost of e capital is directly and
costs are higher an IPO than SEO
and mkt val of debt (bond) are the same) - no taxes Cash flows don’t change, value proportionately related to cap st.
rights issue: allows existing SH first opp to buy new shares and avoid dilution of ownership
Cost of preferred stock – perpetuity: Rp = D/Po - no bankruptcy doesn’t change either WACC is not affected
Rights: cost less than gen cash, protects against dilution and underpricing
D = fixed dividend Po = current price/ share of the preferred stock WACC = (E/V) X RE + (D/V) X RD
𝑓𝑢𝑛𝑑𝑠 𝑡𝑜 𝑏𝑒 𝑟𝑎𝑖𝑠𝑒𝑑 # 𝑜𝑓 𝑜𝑙𝑑 𝑠ℎ𝑎𝑟𝑒𝑠
WACC – required return on our assets based on the market’s perceptions of the risk of those assets # 𝑜𝑓 𝑁𝑒𝑤 𝑆ℎ𝑎𝑟𝑒𝑠 = N: Rights needed to buy 1 share: = RA = (E/V) X RE + (D/V) X RU
𝑠𝑢𝑏𝑠𝑐𝑟𝑖𝑝𝑡𝑖𝑜𝑛 𝑝𝑟𝑖𝑐𝑒 # 𝑜𝑓 𝑛𝑒𝑤 𝑠ℎ𝑎𝑟𝑒𝑠
Capital structure weights RE = RA + (RA – RD) X (D/E)
To receive new stock: they have to give up n rights + sub price
E = mkt value of equity: # O/S shares x price/share D = mkt value of debt = # O/S bonds x bond price Case 2 Val of firm increased by PV of WACC decreases as D/E increases
How many shares currently? – find N from ex rights Px; then plug into # new; old shares
V = mkt value of the firm = D + E D/E = 0.35/1 D = 0.35; E = 1; V = 1.35 - taxes interest tax shield because of taxes on interest
# old shares: # new shares x # ex. Right shares (N) - no bankruptcy Vaue of a lev firm: val of unlev firm payments
cost of preferred equity: Rp = (rate x face value) / share price
Target capital structure = D / E * weights are based on mkt val of firm’s debt and equity Value of a right𝑅 = = Interest is tax deductible, + PV of int tax shield (tax savings)
firm adds debt and Value of Equity = WACC = (E/V) X RE + (D/V)(RD)(1-
Weights : We = E/V = % financed with equity Wd = D/V = % financed with debt New Mkt Val = (current o/s)(stock p) + (rights)(rights price) Price of a right [(N + $) + sub] / N+1 reduces taxes, increasing
New ownership % = shares owned / (new + old shares) val of firm – val of debt Tc)
Taxes and WACC – we are concerned with after tax cash flows CF of the firm
Ex – rights: when stock is selling without a recently declared right, normally two days before the Annual int tax shield: (Assuming perp CF)
Pre tax cost of debt: is based on the current YTM of the firm’s O/S bonds
tax rate x int VU = EBIT (1 – Tc) / RU Cost of equity:
* After tax cost of debt = Rd (1 – Tc) WACC = (E/V) Re + (D/V) Rd (1 -Tc) holder- of record date (when designated as recipient of share right – wont get it after this date) –
payment VL = VU + DTc RE = Ru + (Ru – RD) X (D/E)(1-Tc)
𝐶 𝐶 𝐶 price drops SH cant lose or gain from selling rights; lose net worth if expires
𝑁𝑃𝑉 = −𝐶 + + +⋯+ PV of annual int tax RU is the cost of capital for an
1 + 𝑟 (1 + 𝑟) (1 + 𝑟) Value of a Right after Ex-rights date: Me = Mo – Ro
shield: (perp debt) unlevered firm and equals RA for an
If we use WACC for all projects: 1. Rejects profitable projects with risks less than those of the overall Re= (Me – s) / N Me = ex right stock price; Mo= rights on common SP unlevered firm
Ex rights price per share: Px: (# of rights to buy 1 share)(share p) + sub price / N+1 Pv: annual tax
firm 2. Makes unprofitable investments with risks > overall firm. 3. Increases the overall risk overtime value of firm increases as total debt
sh/debt rate
Pure play approach – used WACC that unique to a particular project, find one or more companies that OG value – value of 1 right or nmv/o/s after rights increases – interest tax shield
PV: [D (Rd)(Tc)]/ Rd
specialize in the product or service – compute beta for each company and take the average. Return for Dilution: loss of existing SH value Flotation: equity to issue: amount required/ 1-f
Case 3 - As D/E increase, prob of bankruptcy increase RA: rate of return
that risk = Beta with CAPM Subjective Approach: consider the project’s risk relative to the overall, if (amount required: direct + indirect (appreciation) costs)
- taxes increases exp bankruptcy on the firm’s assets
the project is more risky that the firm, use a discount rate greater than the WACC OR if the project is # new shares after costs? – use value from equity to issue eq into # new shares eq. - bankruptcy costs -value of firm decreases, WACC increases Rd: firms cost of
less risky that the firm, use a discount rate less than the WACC – reduce error rate Standby Uw: UW agrees to buy any shares that aren’t purchased through the rights offering because more debt is added debt
Company valuation: Dilution: % ownership; mkt val (firm accepts neg NPV projects); book val and EPS – EPS goes down Ex. Inc. is debating whether to convert its all-equity capital structure to 30 percent debt. Currently 6,500 shares
CFA = EBIT (1 – Tc) + Dep – Change in NWC – Capital spending after a new issue when mkt to book val is < 1. outstanding, at $45/ share EBIT = $29,000 per year forever. Debt = 8% int. rate, no taxes. The firm has a dividend
Private issues: term loans(1-5y, dir business loans(repay during life of loan); synd (large, bank/inst,invt payout rate of 100% D owns 100 shares of stock. She prefers the cashflows she receives from the firm while it stays
If CFA is expected to grow at a const. rate g forever; firm value: Vt = CFA*t +1 / WACC -g
leverage-free. Ensure that she receives the same cashflows even if Dundas Inc. issues the debt? Show that her
Flotation cost, WAFC = (E/V) x fe + (D/V) x Fd *True cost: Capital investment / (1-f) grade, LoC); Private placements (like term, lower costs than pub issues) actions keep her cashflow the same even after Dundas Inc. leverage up.
*NPV = PV of future cash flows – True cost WAFC (for internal equity), fa = (D/V) x Fd EX. Corp currently has 9mill O/S shares. The market price is $15/ share. ABC decides to raise additional funds In the all-equity firm, EPS = $29,,500 shares = $4.4615Denise’s cashflow = 100 shares * $4.4615 =
The Huff Co. has just gone public. Under a firm commitment agreement, Huff received $22.50 for each of the 6 via a 1 for 3 rights offer at $12/share. If we assume 100% subscription, what is the value of each right? Current $446.15 EPS of the firm under the proposed capital structure: The market value of the firm is: V = $45(6,500) =
million shares sold. The initial offering price was $23.65 per share, and the stock rose to $25.42 per share in the Market Value = 9m $15 = $135m Total Shares after rights= 9m+ 3m = 12 m Amnt of new funds = 3m $12 = $292,500; Debt issue, D = 0.3($292,500) = $87,750 So, shares repurchased = $87,750 / $45 = 1,950
first few minutes of trading. Huff paid $5,225,500 in direct legal and other costs, and $190,000 in indirect costs. $36 m New Share Price=(135 + 36)/12 = $14.25/share; Value of a Right = Rights-on price – Ex-rights price = 15 NI = $29,000 – .08($87,750) = $21,980 EPS = $21,980 / (6,500 – 1,950) shares = $4.8308
The flotation costs were what percentage of the funds raised? - 14.25 = $0.75 To undo the proposed capital structure and enjoy all-equity cashflow, Denise should sell 30% of her shares, or 30
Ex.Corp. wants to raise $4,230,000 via rights offering. corp currently has 600,000 O/S shares that sell for $55/ shares, and lend the proceeds at 8%. Her cashflow will be: From shares = $4.8308* 70 shares = $338.15; From
Net amount raised = 6m ($22.50) = $135,000,000; Total direct costs = $5,225,500 + ($23.65 - $22.50) (6m) =
share. Its underwriter has a sub price of $30/share and will charge a spread of 6%. If you currently own 6,000 lending = 30* ($45)* (.08) = $108 Total = $446.15
$12,125,500; Total indirect costs = $190,000 + ($25.42 - $23.65) (6m) = $10,810,000; Total costs = $8,160,000 + shares in the company and decide not to participate in the rights offering, how much money can you get by selling Ex. Hadley Co currently is an all equity firm with 52,000 O/S at a market price of $25 a share. EBIT = $83,000.
$10,810,000 = $22,935,500Flotation cost% = $22,935,500/$135,000,000 = 17.73% your rights? Hadley issues $390,000 of debt with 8% interest rate. This $390,000 to repurchase shares of stock. You own
Net proceeds to the company from each share = $30(1 – 0.06) = $28.20/ share. So, to raise the required funds, 2,400 shares of Hadley Co stock; loan out funds at 8% percent int rate. How many of your shares of stock in
( )
PVSimple = F (1+ Kn) n PVCompounding = PVContinuous = ∗
Perp: A𝑃𝑉𝑂: 𝐶 the company must sell = $4,230,000/28.20 = 150,000 shares; Number of rights needed for each new share = Hadley Co must you sell to offset the leverage that the firm is assuming? Assume that you loan out all the funds
( ) 600,000 old shares / 150,000 new shares = 4; So, value of each right = (M0– S)/(N+1) = (55 – 30) / (4+1) = $5; you receive from the sale of your stock.Hadley Co shares redeemed = $390,000 / $25 = 15,600 shares. Shares
Proceeds from selling rights = 6,000 * $5 = $30000 you need to sell = 2,400 shares × (15,600 shares / 52,000 shares) = 720 share
*RR = 10% - Firms must earn 10% on investment to compensate investors for the use of capital they * venture capital – private financing for relatively new businesses in exchange for stock (high risk) Firm value is maximized when the WACC is minimized *increase leverage by issuing debt and
gave to finance the project *angel investor – wealthy individual who invests in early stage ventures (finance in stages) repurchasing O/S *decrease leverage by issuing new shares& retiring O/S debt
*Cost of capital for Bo = risk free rate *Cost of capital depends on the risk of the investment Stages in development seed -> start up -> expansion -> acquisition -> turnaround debt financing increases the fixed interest exp; leverage amplifies the variation in EPS and ROE
ROE = Net income after income and taxes divided by average shareholders equity *choosing a vc: financial strength; obtain and check references; contacts; compatible mngmt; exit *increased debt can mag ROE when prof is good; can also make EPS and ROE more risky
Cost of equity – return that equity investors require on their investment in the firm strategy Steps for a new issue: Obtain perm from BOD -> prep and dist prelim prospectus -> OSC % 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝐸𝑃𝑆 𝐸𝐵𝐼𝑇
1) Dividend growth model: PV of all future dividends - get the stock price at any point in time, 𝐷𝑒𝑔𝑟𝑒𝑒 𝑜𝑓 𝑓𝑖𝑛𝑎𝑛𝑐𝑖𝑎𝑙 𝑙𝑒𝑣𝑒𝑟𝑎𝑔𝑒: 𝑜𝑟
reviews prelim. -> when approved, price is determined and security dealers can begin selling new issue % 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝐸𝐵𝐼𝑇 𝐸𝐵𝐼𝑇 − 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡
Pros: simple, cons: only applicable if currently paying div; need const growth rate; doesn’t consider When EBIT is expected to increase, lev is beneficial
Public issues: * General cash offering: new securities offered for sale to the general public on a cash
risk; sensitive to est growth rate *variability in both ROE and EPS increases when fin leverage is increased; * BE EBIT: EBIT where EPS is
Constant growth: D1 = Do x (1+g) Cost of equity: Re = (D1/ Po) + g basis *Rights offer: new securities are first offered to existing shareholders; Spread: difference b/w
what the synd pays the company and what the security sells for [compensation: buying price – offering the same under current and proposed capital structure. * EBIT >BEP: lev is ben(High EPS); EBIT <BEP:
×( ) ×( )
𝑃 = 𝑃 = = price] Total cash received (bought deal with spread): Total shares x share price x (1-spread) lev in det. (low EPS) - if EBIT is less than BEP – choose unlev option
Grows at constant rate after some time Dt = Do x (1+g)T Net proceed to company for each share: sub price x (1-spread) EPS in all equity firm = EPS in firm with debt
Po: price/share of stock today Dividend: div/share in 1 year Types of underwriting: *Bought deal (firm commitment): issuer self entire issue to one underwriting EBIT/ # of shares = (EBIT – interest)/ # of shares
k:expected rate of return – discount rate g: growth rate of company (future) General case: price today synd and underwriter makes $ on spread; assume risk of not selling entire issue *Best efforts NI = EBIT – Interest EPS = NI / Shares O/S
of share of stock is the OV of all its future div To find EPS: Share price share price x repurchase total shares NI EPS
underwriting(reg UW): UW makes best effort to sell but doesn’t guarantee to sell the entire issue;
Po = E D/ (1+r)1 + D/(1+r)2 + D/(1+r)3…. Homemade leverage: use of personal borrowing to change the overall amount of fin lev to which the
offer may be pulled if there isn’t enough interest at the offer price *Dutch Auction (Uniform price): not
Estimating growth: g = (1- Payout Ratio)(ROE) individual is exposed.
set fixed price; price is det based on bids in an auction – (price w most shares x # shares) Selling
Earnings next year: earnings this year + RE this year x return on Re Bankruptcy costs *Direct costs: legal, admin – causes additional loses, disincentive to debt financing
Period: when issue is being sold to the public, the synd agrees not to sell securities for less than the
(1-Payout Ratio) = Retention Ratio *Financial distress – prob w meeting debt obligations *Indirect costs – lost sales, interrupted ops and
g = Retention ratio x ROE Retention ratio = Re / net income offering price until synd dissolves UW is permitted to buy shares if the mkt price falls below the
loss of employees b/c mngmt spends time worrying about avoiding bankruptcy than running the
DDM Zero growth rate: constant dividend offering price to stabilize from down pressure if unsold, leave or sell at mkt price. Overallotment
business.
Perpetuity: 𝑃 = (Green shoe provision): UW buy additional shares at the OG price offering and immediately sell them
static theory of cap structure: firm borrows up to point where the tax benefit from an extra $ is debt =
– gives protection for lead UW as they perform their price stabilization function Lock up agreement:
Return on equity = net income after interest and taxes/ avg. common SH equity cost of increased prob of fin stress (WACC in minimized)
specifies how long insiders must wait after an IPO before they can sell stock (180) – if with VC could
2. SML Approach E (Re) – Rf + Be x [E(Rm) – Rf] RR: (Re) = Rf + Be x [Rm – Rf] *tax ben is only important if the firm has a large tax liability
have loss when the VC cashes out. Quiet period: communications are limited to ordinary
Market risk premium: E[Rm] – Rf * Assumes future risks are similar to past risks; applies to firms that *the greater the risk of fin distress, the less debt will be optimal for the firm
announcements (40) – end: favourable buy recommendation
retain all earnings B = beta of stock Rf = risk free rate Rm = Expected mkt return Pecking Order: internal issue debt (inverse rel w profit and debt equity (last resort) [cap st is
Underpricing: P 1st day of SEO – Offer price in IPO (risky: attract)
Expected return – return on any risky asset expected in the future dictated by its need for ext. fin]
SEO: man info, debt usage, issue costs – negative signal
Reduction of Rf will increase a firm’s cost of equity Prop 1: Firm value Prop 2: WACC
*Larger firms can raise equity more easily*cost with underpricing can exceed the direct costs*issue
Cost of debt = YTM – return lenders require on the firm’s debt – NOT the coupon rate (unless face val Case 1 VU = EBIT/ REU = VL = EL + DL Cost of e capital is directly and
costs are higher an IPO than SEO
and mkt val of debt (bond) are the same) - no taxes Cash flows don’t change, value proportionately related to cap st.
rights issue: allows existing SH first opp to buy new shares and avoid dilution of ownership
Cost of preferred stock – perpetuity: Rp = D/Po - no bankruptcy doesn’t change either WACC is not affected
Rights: cost less than gen cash, protects against dilution and underpricing
D = fixed dividend Po = current price/ share of the preferred stock WACC = (E/V) X RE + (D/V) X RD
𝑓𝑢𝑛𝑑𝑠 𝑡𝑜 𝑏𝑒 𝑟𝑎𝑖𝑠𝑒𝑑 # 𝑜𝑓 𝑜𝑙𝑑 𝑠ℎ𝑎𝑟𝑒𝑠
WACC – required return on our assets based on the market’s perceptions of the risk of those assets # 𝑜𝑓 𝑁𝑒𝑤 𝑆ℎ𝑎𝑟𝑒𝑠 = N: Rights needed to buy 1 share: = RA = (E/V) X RE + (D/V) X RU
𝑠𝑢𝑏𝑠𝑐𝑟𝑖𝑝𝑡𝑖𝑜𝑛 𝑝𝑟𝑖𝑐𝑒 # 𝑜𝑓 𝑛𝑒𝑤 𝑠ℎ𝑎𝑟𝑒𝑠
Capital structure weights RE = RA + (RA – RD) X (D/E)
To receive new stock: they have to give up n rights + sub price
E = mkt value of equity: # O/S shares x price/share D = mkt value of debt = # O/S bonds x bond price Case 2 Val of firm increased by PV of WACC decreases as D/E increases
How many shares currently? – find N from ex rights Px; then plug into # new; old shares
V = mkt value of the firm = D + E D/E = 0.35/1 D = 0.35; E = 1; V = 1.35 - taxes interest tax shield because of taxes on interest
# old shares: # new shares x # ex. Right shares (N) - no bankruptcy Vaue of a lev firm: val of unlev firm payments
cost of preferred equity: Rp = (rate x face value) / share price
Target capital structure = D / E * weights are based on mkt val of firm’s debt and equity Value of a right𝑅 = = Interest is tax deductible, + PV of int tax shield (tax savings)
firm adds debt and Value of Equity = WACC = (E/V) X RE + (D/V)(RD)(1-
Weights : We = E/V = % financed with equity Wd = D/V = % financed with debt New Mkt Val = (current o/s)(stock p) + (rights)(rights price) Price of a right [(N + $) + sub] / N+1 reduces taxes, increasing
New ownership % = shares owned / (new + old shares) val of firm – val of debt Tc)
Taxes and WACC – we are concerned with after tax cash flows CF of the firm
Ex – rights: when stock is selling without a recently declared right, normally two days before the Annual int tax shield: (Assuming perp CF)
Pre tax cost of debt: is based on the current YTM of the firm’s O/S bonds
tax rate x int VU = EBIT (1 – Tc) / RU Cost of equity:
* After tax cost of debt = Rd (1 – Tc) WACC = (E/V) Re + (D/V) Rd (1 -Tc) holder- of record date (when designated as recipient of share right – wont get it after this date) –
payment VL = VU + DTc RE = Ru + (Ru – RD) X (D/E)(1-Tc)
𝐶 𝐶 𝐶 price drops SH cant lose or gain from selling rights; lose net worth if expires
𝑁𝑃𝑉 = −𝐶 + + +⋯+ PV of annual int tax RU is the cost of capital for an
1 + 𝑟 (1 + 𝑟) (1 + 𝑟) Value of a Right after Ex-rights date: Me = Mo – Ro
shield: (perp debt) unlevered firm and equals RA for an
If we use WACC for all projects: 1. Rejects profitable projects with risks less than those of the overall Re= (Me – s) / N Me = ex right stock price; Mo= rights on common SP unlevered firm
Ex rights price per share: Px: (# of rights to buy 1 share)(share p) + sub price / N+1 Pv: annual tax
firm 2. Makes unprofitable investments with risks > overall firm. 3. Increases the overall risk overtime value of firm increases as total debt
sh/debt rate
Pure play approach – used WACC that unique to a particular project, find one or more companies that OG value – value of 1 right or nmv/o/s after rights increases – interest tax shield
PV: [D (Rd)(Tc)]/ Rd
specialize in the product or service – compute beta for each company and take the average. Return for Dilution: loss of existing SH value Flotation: equity to issue: amount required/ 1-f
Case 3 - As D/E increase, prob of bankruptcy increase RA: rate of return
that risk = Beta with CAPM Subjective Approach: consider the project’s risk relative to the overall, if (amount required: direct + indirect (appreciation) costs)
- taxes increases exp bankruptcy on the firm’s assets
the project is more risky that the firm, use a discount rate greater than the WACC OR if the project is # new shares after costs? – use value from equity to issue eq into # new shares eq. - bankruptcy costs -value of firm decreases, WACC increases Rd: firms cost of
less risky that the firm, use a discount rate less than the WACC – reduce error rate Standby Uw: UW agrees to buy any shares that aren’t purchased through the rights offering because more debt is added debt
Company valuation: Dilution: % ownership; mkt val (firm accepts neg NPV projects); book val and EPS – EPS goes down Ex. Inc. is debating whether to convert its all-equity capital structure to 30 percent debt. Currently 6,500 shares
CFA = EBIT (1 – Tc) + Dep – Change in NWC – Capital spending after a new issue when mkt to book val is < 1. outstanding, at $45/ share EBIT = $29,000 per year forever. Debt = 8% int. rate, no taxes. The firm has a dividend
Private issues: term loans(1-5y, dir business loans(repay during life of loan); synd (large, bank/inst,invt payout rate of 100% D owns 100 shares of stock. She prefers the cashflows she receives from the firm while it stays
If CFA is expected to grow at a const. rate g forever; firm value: Vt = CFA*t +1 / WACC -g
leverage-free. Ensure that she receives the same cashflows even if Dundas Inc. issues the debt? Show that her
Flotation cost, WAFC = (E/V) x fe + (D/V) x Fd *True cost: Capital investment / (1-f) grade, LoC); Private placements (like term, lower costs than pub issues) actions keep her cashflow the same even after Dundas Inc. leverage up.
*NPV = PV of future cash flows – True cost WAFC (for internal equity), fa = (D/V) x Fd EX. Corp currently has 9mill O/S shares. The market price is $15/ share. ABC decides to raise additional funds In the all-equity firm, EPS = $29,,500 shares = $4.4615Denise’s cashflow = 100 shares * $4.4615 =
The Huff Co. has just gone public. Under a firm commitment agreement, Huff received $22.50 for each of the 6 via a 1 for 3 rights offer at $12/share. If we assume 100% subscription, what is the value of each right? Current $446.15 EPS of the firm under the proposed capital structure: The market value of the firm is: V = $45(6,500) =
million shares sold. The initial offering price was $23.65 per share, and the stock rose to $25.42 per share in the Market Value = 9m $15 = $135m Total Shares after rights= 9m+ 3m = 12 m Amnt of new funds = 3m $12 = $292,500; Debt issue, D = 0.3($292,500) = $87,750 So, shares repurchased = $87,750 / $45 = 1,950
first few minutes of trading. Huff paid $5,225,500 in direct legal and other costs, and $190,000 in indirect costs. $36 m New Share Price=(135 + 36)/12 = $14.25/share; Value of a Right = Rights-on price – Ex-rights price = 15 NI = $29,000 – .08($87,750) = $21,980 EPS = $21,980 / (6,500 – 1,950) shares = $4.8308
The flotation costs were what percentage of the funds raised? - 14.25 = $0.75 To undo the proposed capital structure and enjoy all-equity cashflow, Denise should sell 30% of her shares, or 30
Ex.Corp. wants to raise $4,230,000 via rights offering. corp currently has 600,000 O/S shares that sell for $55/ shares, and lend the proceeds at 8%. Her cashflow will be: From shares = $4.8308* 70 shares = $338.15; From
Net amount raised = 6m ($22.50) = $135,000,000; Total direct costs = $5,225,500 + ($23.65 - $22.50) (6m) =
share. Its underwriter has a sub price of $30/share and will charge a spread of 6%. If you currently own 6,000 lending = 30* ($45)* (.08) = $108 Total = $446.15
$12,125,500; Total indirect costs = $190,000 + ($25.42 - $23.65) (6m) = $10,810,000; Total costs = $8,160,000 + shares in the company and decide not to participate in the rights offering, how much money can you get by selling Ex. Hadley Co currently is an all equity firm with 52,000 O/S at a market price of $25 a share. EBIT = $83,000.
$10,810,000 = $22,935,500Flotation cost% = $22,935,500/$135,000,000 = 17.73% your rights? Hadley issues $390,000 of debt with 8% interest rate. This $390,000 to repurchase shares of stock. You own
Net proceeds to the company from each share = $30(1 – 0.06) = $28.20/ share. So, to raise the required funds, 2,400 shares of Hadley Co stock; loan out funds at 8% percent int rate. How many of your shares of stock in
( )
PVSimple = F (1+ Kn) n PVCompounding = PVContinuous = ∗
Perp: A𝑃𝑉𝑂: 𝐶 the company must sell = $4,230,000/28.20 = 150,000 shares; Number of rights needed for each new share = Hadley Co must you sell to offset the leverage that the firm is assuming? Assume that you loan out all the funds
( ) 600,000 old shares / 150,000 new shares = 4; So, value of each right = (M0– S)/(N+1) = (55 – 30) / (4+1) = $5; you receive from the sale of your stock.Hadley Co shares redeemed = $390,000 / $25 = 15,600 shares. Shares
Proceeds from selling rights = 6,000 * $5 = $30000 you need to sell = 2,400 shares × (15,600 shares / 52,000 shares) = 720 share
