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Topics: Net present value, Corporate finance, Finance Pages: 8 (1317 words) Published: November 5, 2014

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CFA Level 1
AAA |
Chapter 1 - 5

Chapter 6 - 10

Chapter 11 - 15

Chapter 16 - 17
11. Corporate Finance
12. Securities Markets
13. Equity Investments
14. Fixed Income Investments
15. Derivatives
11.1 Introduction
11.2 Agent-Principle Relationship
11.3 Capital Budgeting Basics
11.4 The Cost of Capital
11.5 Cost of Retained Earnings
11.6 Cost of Newly Issued Stock
11.7 Target Capital Structure
11.8 Marginal Cost of Capital
11.9 Factors Affecting the Cost of Capital
11.10 Payback Period
11.11 Net Present Value (NPV) and the Internal Rate of Return (IRR) 11.12 The NPV Profile
11.13 Cash Flow and NPV Applications
11.14 Advantages and Disadvantages of the NPV and IRR Methods 11.15 Applying NPV Analysis to Project Decisions
11.16 Comparing Projects With Unequal Lives
11.17 Types of Risk
11.18 Risk-Analysis Techniques
11.19 Security Market Line and Beta Basics
11.20 Factors that Influence a Company's Capital-Structure Decision 11.21 Business and Financial Risk
11.22 Operating Leverage and its Effects on a Project's Expected Rate of Return 11.23 Financial Leverage
11.24 Sales and Leverage
11.25 Effects of Debt on the Capital Structure
11.26 Tax and Bankruptcy Costs
11.27 The MM Capital Structure vs. The Tradeoff Theory of Leverage 11.28 Signaling Prospects Through Financing Decisions
11.29 Degree of Total Leverage
11.30 Dividend Theories
11.31 Dividend Growth Rate and the Effect of Changing Dividend Policy 11.32 Setting Dividends
11.33 Dividend Payment Procedures
11.34 Stock Dividends and Repurchases

Corporate Finance - Effects of Debt on the Capital Structure Using Greater Amounts of Debt
Recall that the main benefit of increased debt is the increased benefit from the interest expense as it reduces taxable income. Wouldn't it thus make sense to maximize your debt load? The answer is no.

With an increased debt load the following occurs:
Interest expense rises and cash flow needs to cover the interest expense also rise. Debt issuers become nervous that the company will not be able to cover its financial responsibilities with respect to the debt they are issuing.

Stockholders become also nervous. First, if interest increases, EPS decreases, and a lower stock price is valued. Additionally, if a company, in the worst case, goes bankrupt, the stockholders are the last to be paid retribution, if at all.

In our previous examples, EPS increased with every increase in our debt-to-equity ratio. However, in our prior discussions, an optimal capital structure is some combination of both equity and debt that maximizes not only earnings but also stock price. Recall that this is best implied by the capital structure that minimizes the company's WACC.

Example:
The following is Newco's cost of debt at various capital structures. Newco has a tax rate of 40%. For this example, assume a risk-free rate of 4% and a market rate of 14%. For simplicity in determining stock prices, assume Newco pays out all of its earnings as dividends.

Figure 11.15: Newco's cost of debt at various capital structures

At each level of debt, calculate Newco's WACC, assuming the CAPM model is used to calculate the cost of equity.

Answer:
At debt level 0%:
Cost of equity = 4% + 1.2(14% - 4%) = 16%
Cost of debt = 0% (1-40%) = 0%
WACC = 0%(0%) + 100%(16%) = 16%
Stock price = $18.00/0.16 = $112.50

At debt level 20%:
Cost of equity = 4% + 1.4(14% - 4%) = 18%
Cost of debt = 4%(1-40%) = 2.4%
WACC = 20%(2.4%) + 80%(18%) = 14.88%
Stock price = $22.20/0.1488 = $149.19

At debt level 40%:
Cost of equity = 4% + 1.6(14% - 4%) = 20%
Cost of debt = 6% (1-40%) = 3.6%
WACC = 40%(3.6%) + 60%(20%) = 13.44%...
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