Solution manual financial management 10e by keown chapter 16

The cost of capital – capital structure argument may be characterized by this question: Can the firm affect its overall cost of funds by varying the mixture of financing sources used?. I

CHAPTER 16

Planning the Firm's Financing Mix       

CHAPTER ORIENTATION

This chapter concentrates on the way the firm arranges its sources of funds. The cost ofcapital   –   capital   structure   argument   is   highlighted   A   moderate   view   on   the   effect   offinancial leverage use on the composite cost of capital is adopted. Later, techniques useful tothe   financial   officer   faced   with   the   determination   of   an   appropriate   financing   mix   aredescribed

CHAPTER OUTLINE

I Introduction

A A distinction between financial structure and capital structure

1 Financial structure is the mix of items on the right-hand side of the

firm's balance sheet

2 Capital structure is the mix of long-term sources of funds

3 The main focus will be capital structure management and not the

appropriate maturity composition of the sources of funds

B The objective of capital structure management is to mix the permanent

sources of funds in a manner that will maximize the company's commonstock price This proper mix of fund sources is referred to as the optimalcapital structure

II A glance at capital structure theory

A The cost of capital – capital structure argument may be characterized by this

question: Can the firm affect its overall cost of funds by varying the mixture

of financing sources used?

B If the firm's cost of capital can be affected by the degree to which it uses

financial leverage, then capital structure management is important

C The analytical discussion revolves around a simplified version of the basic

dividend valuation model

1 It assumes (a) cash dividends paid will not change over the infinite

holding period, and (b) the firm retains none of its current earnings

2 The analytical setting for the discussion of capital structure theory

assumes (a) corporate income is not subject to any taxation, (b)capital structures consist of only stocks and bonds, (c) the expectedvalues of all investors' forecasts of the future levels of net operatingincome for each firm are identical, and (d) securities are traded inperfect or efficient financial markets

III Extreme position 1: The Independence Hypothesis (NOI Theory)

A When business income is not subject to taxation, the firm's composite cost

of capital and common stock price are both independent of the degree towhich the firm chooses to use financial leverage

B Total market value of the firm's outstanding securities is unaffected by the

arrangement of the right-hand side of the balance sheet

C The independence hypothesis rests upon what is called the net operating

income (NOI) approach to valuation

D The use of a greater degree of financial leverage may result in greater

earnings and dividends, but the firm's cost of common equity will rise atprecisely the same rate as the earnings and dividends

IV Extreme position 2: The Dependence Hypothesis (NI Theory)

A The dependence hypothesis suggests that both the weighted cost of capital

and the firm's common stock price are affected by the firm's use of financialleverage

B Regardless of the firm's use of debt financing, both its cost of debt and

equity capital will not be affected by capital structure adjustments

C The cost of debt is less than the cost of common equity, implying greater

financial leverage use will lower the weighted cost of capital indefinitely

D The dependence hypothesis rests upon what is called the net income (NI)

approach to valuation

V A moderate position: Corporate Income is Taxed and Firms May Fail

A Admits to the following facts: (1) interest expense is tax deductible, and

(2) the probability of suffering bankruptcy costs is directly related to theuse of financial leverage

B When interest expense is tax deductible, the sum of the cash flows that the

firm could pay to all contributors of corporate capital is affected by itsfinancing mix This is not the case when an environment of no corporatetaxation is presumed

1 The amount of the tax shield on interest may be calculated as

Tax shield = r (M) (t) where r = the interest rate paid on outstanding debt

M = the principal amount of the debt

t = the firm's tax rate

2 This position presents the view that the tax shield must have value inthe marketplace

3 Therefore, financial leverage affects firm value, and it must alsoaffect the cost of corporate capital

C There is some point at which the expected cost of default is large enough to

outweigh the tax shield advantage of debt financing At that point, the firmwill turn to common equity financing

D The determination of the firm's financing mix is centrally important to both

the financial manager and the firm's owners

VI Firm Value, Agency Costs, the Static Trade-off Theory, and the Pecking Order

Theory

A To ensure that agent-managers act in the stockholders' best interest requires

1 Proper incentives to do so through compensation plans and

perquisites

2 Decisions that are monitored through bonding, auditing financial

statements, limiting decisions, and reviewing the perquisites

B Agency problems stem from conflicts of interest between firm management

and owners; capital structure management encompasses a natural conflictbetween stockholders and bondholders

1 To reduce the conflict of interest, creditors and stockholders may

agree to include several protective covenants in the bond contract

2 Monitoring costs should differ in direct proportion to low or high

levels of leverage

C Static trade-off theory distinguished from pecking order theory

1 Static trade-off theory provides for the identification of a precise

optimum financing mix This financing mix should logically

determine the firm's targeted leverage ratio.

2 Static trade-off theory "prices" both expected financial distress costs

and agency costs

3 Pecking order theory suggests that firm's finance projects within a

well-defined hierarchy that begins with internally generated fundsand ends with new common equity (the least desired funds source)

4 Thus, pecking order theory provides no precisely defined target

leverage ratio since typical leverage metrics just reflect the firm'scumulative external financing needs over time

VII Agency costs, free cash flow, and capital structure

A Free cash flow, as defined by Professor Michael C Jensen, is the "cash flow

in excess of that required to fund all projects that have positive net presentvalues when discounted at the relevant cost of capital."

B Like the pecking order theory, the free cash flow theory of capital structure

does not give a precise solution that determines the firm's optimal financingmix

C The free cash flow theory does provide a framework and rationale for

justifying why shareholders and their boards of directors might use moredebt (financial leverage) to control management behavior and decisions

D The upshot of all of these theories and perspectives is that the determination

of the firm's financing mix is centrally important to the financial manager.The firm's stockholders are indeed affected by capital structure decisions;these decisions affect the firm's stock price

VIII Basic tools of capital structure management

A The use of financial leverage has two effects on the earnings stream flowing

to common stockholders: (l) the added variability in the earnings per share(EPS) stream that accompanies the use of fixed-charge securities and (2) thelevel of EPS at a given earnings before interest and taxes level (EBIT)associated with a specific capital structure

B The objective of EBIT-EPS analysis is to find the EBIT level that will

equate EPS regardless of the financing plan chosen

1 A graphic or algebraic analysis can be used

2 By allowing for sinking fund payments, the analysis can focus upon

uncommitted earnings per share

3 EBIT-EPS analysis considers only the level of the earnings stream

and ignores the variability in it

C Comparative leverage ratios involve the computation of various balance

sheet leverage ratios and coverage ratios

D The use of industry norms in conjunction with comparative leverage ratios

can aid in arriving at an appropriate financing mix

E Cash flow analysis (company-wide cash flows) is the study of projected

impact of capital structure decisions on corporate cash flows According tothis tool, the appropriate level of financial leverage is reached when thechance of running out of cash is exactly equal to that which managementwill assume An underlying assumption is that management's risk-bearingpreferences are conditioned by the investing marketplace

IX The Multinational Firm: Beware of Currency Risk

A Currency risk exists for firms that have sales in non-U.S markets

B Earnings must be converted from foreign currencies into dollars and

reported in the firm’s financial statements

C Variations in exchange rates impact firm’s overall earnings

1 This can impact stock price, negatively if foreign currency

depreciated in value against the dollar or positively if the currencyappreciated in value

2 Firms with high exposure to currency risk may choose to minimize

other financial risk

X How financial managers use this material

A The opinions and practices of financial executives reinforce the major topics

covered in this chapter

B Target debt ratios are widely used by financial officers

C Executives operationalize debt capacity in different ways The most popular

approach is to define the firm's debt capacity as a target percent of totalcapitalization

D Changes in the aggregate business environment, known as business cycles,

affect capital structure decisions Some phases of the cycle favor debtfinancing over equity financing; in other phases equity financing ispreferred

E The single most important factor that should affect the firm's financing mix

is the underlying nature of the business in which it operates A firm'sbusiness risk must be carefully assessed

ANSWERS TO END-OF-CHAPTER QUESTIONS

16-1 (a) Financial structure: the mix of all items that appear on the right-hand side

of the company's balance sheet

(b) Capital structure: the mix of long-term funds used by the firm

(c) Optimal capital structure: the mix of long-term funds that will minimize the

composite cost of capital for raising a given amount of funds

(d) Debt capacity: the maximum proportion of debt that the firm can include in

its capital structure and still maintain its lowest composite cost of capital.16-2 The decision to use financial leverage by the firm affects both the level and

variability of the EPS flowing to the common stockholders EBIT-EPS analysisdeals only with the level (amount) of EPS available under a given financing plan.The variability in the earnings stream associated with the plan is ignored EBIT-EPS analysis then disregards the riskiness inherent to a particular financingalternative

16-3 The objective of capital structure management is to mix the permanent sources of

funds used by the firm in a manner that will maximize the company's commonstock price

16-4 Balance sheet leverage ratios compare the firm's use of funds supplied by creditors

to those supplied by owners The inputs to these metrics come from the company'sbalance sheet Coverage ratios relate the earnings or cash flow amounts that areavailable for servicing financing contracts to the associated financing costs Theinputs to computing coverage ratios generally come from the company's incomestatement At times, footnotes to the financial statements might have to beconsulted to complete some coverage ratios Table 16-7 in the text identifies thecalculation methods for several popular leverage ratios

16-5 If revenues from sales are highly volatile, then other things being equal, cash flows

will be volatile This would make it difficult to meet, on a timely basis, a largeamount of fixed financing costs Because of this, a high degree of financial riskwill be avoided by firms that operate in industries which experience large salesfluctuations

16-6 If the firm's overall cost of capital is not affected by varying the mixture of financing

sources used, then capital structure management would be a meaningless activity.Likewise, this infers that if the value of the firm is independent of the firm'sfinancing mix, then capital structure management is a sterile process

16-7 Within the realm of capital structure theory, the independence hypothesis offers that

both common stock price and the composite cost of capital are not affected by thefirm's use of financial leverage This presumes that interest expense is not taxdeductible

16-8 Professors Modigliani and Miller are leading proponents of this theory

16-9 This means that the shape of the firm's composite cost of capital curve is

saucer-shaped, or U-saucer-shaped, with respect to the use of financial leverage Over moderatedegrees of leverage use, the overall cost of capital decreases Throughout theoptimal range of leverage use, the cost of capital curve is relatively flat Atexcessive degrees of leverage use, the overall cost of capital rises The result is asaucer shaped cost of capital curve

16-10 The EBIT-EPS indifference point is the level of EBIT that will equate EPS

regardless of the financing plan ultimately chosen from a set of two alternatives.16-11 UEPS is the earnings available to the common shareholders minus sinking fund

payments that have been honored

16-12 Industry norms for the various balance sheet leverage ratios and coverage ratios

only provide rough guidelines for the design of the firm's financing mix Norms areusually averages or some other measure of central tendency Few firms in realitywill have the same operating characteristics as a hypothetical "normal" firm Thus,norms are best used on an "exception" basis That is, if the firm's capital structureratios differ widely from the norms, then a defensible explanation for that conditionshould be available

16-13 Free cash flow is the cash flow in excess of that required to fund all projects that

have positive net present values when discounted at the relevant cost of capital.16-14 The free cash flow theory of capital structure suggests that management works

"best" under the threat of financial failure By increasing the use of inducing instruments in the firm's capital structure, then shareholders will enjoyincreased control over management This, in turn, reduces the agency costs of freecash flow

leverage-16-15 During the 1980s several studies suggest that financial leverage use increased

substantially compared to the 1970s This trend began reversing in the early 1990s

as the market for common equities improved

16-16 It makes sense for financial managers to be familiar with the business cycle because

financial market and product market conditions can change abruptly during thecycle This means that company policies and decisions may differ over differentphases (say expansion or contraction) of the cycle

16-17 Financial managers clearly favor the use of internally generated equity in the

financing of capital budgets

SOLUTIONS TO END-OF-CHAPTER PROBLEMS

Solutions to Problem Set A

16-1A

a FC = Interest + Sinking Fund

FC = ($15 Million) (.18) +

years30

so, CBr = $2,000,000 + $950,000 - $3,200,000

CBr = -$250,000

c We see that the company has a preference for a $2 million cash balance The

combination of the recessionary period and the proposed issue of bonds would put the firm’s recessionary cash balance (CBr) at -$250,000 The combination of the negative number and the statement that the firm likes a cash balance of $2 million suggest strongly that the proposed bond issue be postponed

16-2A The following formula can be used to solve for the amount of cash collections on

sales, CS, required to provide the desired end of year cash balance:

CBr = desired cash balance at end of recessionary period = $200,000

C0 = cash balance at beginning of period = $200,000

OR = other cash receipts (as percent of sales receipts) = 5%

Pa = payroll expenditures (as percent of sales receipts) = 30%

RM = raw material payments (as percent of sales receipts) = 25%

En = total nondiscretionary expenditures = $500,000

FC = fixed financial charges = $140,000thus

$000,500

$000,200

$000,200

16-3A At the EBIT indifference level:

EPS (All Debt Plan) = EPS (Debt and Equity Plan)that is,

AllDebt

S

SF]

Pt)I)(1[(EBIT   

=

DebtEquity

S

SF]Pt)I)(1[(EBIT   

100,000

$50,000]

.35)

$90,000)(1[(EBIT  

=

30,000)(100,000

$20,000]

.35)

$32,000)(1[(EBIT

=

13

$40,800.65EBIT 

EBIT = $514,10316-4A

(a)

s

S

Pt)I)(1(EBIT  

=

b

S

Pt)I)(1(EBIT  

1,000,000

00.5)

$0)(1(EBIT  

=

700,000

00.5)1

EBIT = $2,000,000

EBIT $2,000,000 $2,000,000Interest 0 600,000EBT $2,000,000 $1,400,000Taxes 1,000,000 700,000

NI $1,000,000 $ 700,000

P 0 0EAC $1,000,000 $ 700,000EPS $ 1.00 $ 1.00(c) See following analysis chart

(d) Since $2,400,000 exceeds $2,000,000, the levered plan (Plan B) will provide

for higher EPS

o

t

P

E = 30

$

6 = 20%

In the all equity firm Kc = Ko, Thus, Ko = 20%

(c) Kc =

0.30

$

21.6 = 20.7%

(1) EBIT $5,400,000

- Interest 120,000EAC $5,280,000

00.621

6 

= 0.035 or 3.5%

(3)

%0.20

%0.20

%7

+ (8.0%)27

5.1

= 20.0%

16-6A

(a)

shares80,000

0.4)0)(1(EBIT 

=

shares40,000

0.4)1

EBIT = $240,000

EBIT $240,000 $240,000Interest 0 120,000EBT $240,000 $120,000Taxes (40%) 96,000 48,000

0.34)0)(1

(EBIT 

=

shares50,000

0.34)1

EBIT = $220,000(b) Since $300,000 exceeds the indifference level of $220,000 from part (a), the

levered alternative (Plan B) will generate the higher EPS

(c) Here we compute EPS for each financing plan, apply the relevant

price/earnings ratios, and, thereby, forecast a common stock price for eachplan Thus, we have:

Plan A Plan BEBIT $300,000 $300,000Interest 0 110,000EBT $300,000 $190,000Taxes (34%) 102,000 64,600

16-8A

(a)

shares75,000

0.34)0)(1

(EBIT 

=

shares50,000

0.34)1

EBIT = $450,000

EBIT $450,000 $450,000Interest 0 150,000

16-9A

(a)

shares100,000

0.5)

$0)(1(EBIT 

=

shares50,000

0.5)1

EBIT = $640,000

EBIT $640,000 $640,000Interest 0 320,000EBT $640,000 $320,000Taxes (50%) 320,000 160,000

P 0 0EAC $320,000 $160,000

÷ No of Common Shares 100,000 50,000EPS $ 3 .20 20$ 3(c) Since $800,000 exceeds the calculated indifference level of $640,000, the

levered plan (Plan B) will generate the higher EPS

(d) To solve this part of problem 10-6A, compute EPS under each financial

alternative Then apply the relevant price-earnings ratio for each plan Anassociated common stock price for each plan can then be forecast Thisfollows

Plan A Plan BEBIT $800,000 $800,000Interest 0 320,000

= Projected Stock Price $48.00 $48.00

The riskiness is reflected in a lower P-E ratio for Plan B of 10 versus that of

12 for Plan A (the all common equity plan) The decision now can logicallyshift to Plan A (unlevered) The investors obtain the same stock price of

$48.00 under both plans The risk of Plan A is lower, so it would bepreferable

FC = $1,500,000 + $500,000 = $2,000,000(b) CBr = CB0 + NCFr - FC

where:

CB0 = $1,000,000

FC = $2,000,000and,

NCFr = $4,300,000 - $3,400,000 = $900,000

so, CBr = $1,000,000 + $900,000 - $2,000,000CBr = - $100,000

(c) We see that the company has a preference for a $1 million cash balance The

combination of the recessionary period and the proposed issue of bondswould put the firm's recessionary cash balance (CBr ) at -$100,000 Thecombination of this negative number and the statement that the firm likes acash balance of $1 million suggests strongly that the proposed bond issue bepostponed

=

40,000

0.4)1

EBIT = $300,000

EBIT $300,000 $300,000Interest 0 100,000

b

S

Pt)I)(1(EBIT  

1,400,000

00.5)

$0)(1(EBIT  

=

1,000,000

00.5)1

EBIT = $1,120,000

EBIT $1,120,000 $1,120,000Interest 0 320,000EBT $1,120,000 $ 800,000

NI $ 560,000 $ 400,000

P 0 0EAC $ 560,000 $ 400,000EPS $ 0.40 $ 0.40(c) Analysis chart is on the following page

(d) Since $1,800,000 exceeds $1,120,000, the levered plan (Plan B) will provide

for higher EPS

16-13A

(a) At EBIT of $1,800,000 the respective EPS amounts are:

Plan A = $0.64 (rounded from $0.6429)Plan B = $0.74

The stock prices then are:

Plan A: ($0.64) (12) = $7.68Plan B: ($0.74) (10) = $7.40

So Plan A offers the higher stock price

(b) ($0.74) (PE) = $7.68

PE = = 10.378 times(c) The penalized price/earnings ratio resulting from use of financial leverage

may well favor the unlevered financing plan when the ultimate effect on thefirm's stock price is considered