İŞLETME FİNANSI II

Financial leverage is an indicator of financial risk and occurs in case of borrowing

There are many factors affecting the business risk of a firm, however, to summarize we can cite the following:

There are many factors affecting the business risk of a firm, however, to summarize we can cite the following:

The net income approach advocates that a firm can boost its value by lowering its WACC, which is possible by increasing financial leverage in its capital structure. In this approach, it is assumed that the cost of debt is always less than the cost of equity and that the increase in the debt ratio does not lead to a change in the risk perception of the investors. Therefore, both the cost of debt and equity remain constant no matter how heavily debt capital is induced to the capital structure of the firm. Consequently, in an environment where there are no taxes, the higher the financial leverage, the lower the WACC, thus the higher the firm value. The net income approach ignores the rising bankruptcy risk at higher leverage. In real life conditions, the likelihood of financial distress heightens both the cost of debt and equity raising the WACC.

The model assumes that the cost of debt, the WACC and the value of the firm is irrespective of financial leverage. The value of the firm is its net operating income which is also independent of leverage, capitalized at the constant WACC. Therefore, the firm value will remain unchanged by the financing decisions under the assumption of no corporate taxes.

A traditional approach is an intermediate model, compromising between the net income approach and the net operating income approach. Traditional approach assumes an optimal capital structure where the WACC is minimized and the value of the firm is maximized. The model suggests that up to a certain level of leverage, the use of debt financing reduces the WACC, but after that optimal level, the WACC escalates depressing the firm value. The cost of debt remains constant more or less up to a certain level, however, above that level, interest rate rises with the increase in the likelihood of financial distress. The same is true for the cost of equity since stockholders require a higher return at higher financial leverage. Therefore, the WACC decreases up to a certain level of debt financing, but after that optimal point, it inclines rapidly

Franco Modigliani and Merton Miller (MM) are the founders of modern capital structure theory. Their first article (1958) is one of the most influential studies in academia. MM’s study is based on the following assumptions: 1. Capital markets are perfect with rational investors that can freely buy and sell assets. 2. Investors have homogenous expectations. 3. There are no bankruptcy costs. 4. There are no taxes. 5. There are no transaction costs in financial asset trading. 6. Investors and companies can borrow at the same rate with no restrictions. 7. All investors can access the same information as the managers of a company without paying any information cost. 8. Operating income (EBIT) is not affected by the use of debt. 9. All earnings are distributed to stockholders as dividends (dividend payout ratio is 100%). 10. Well-informed investors have the option to arbitrage.

Agency theory suggests that agency problems may arise if managers (agents) pursue different objectives other than those of the shareholders (principals). Shareholders’ seek for wealth maximization which can be attained by the maximization of the value of the firm. However, managers often waste shareholders’ wealth by consuming perquisites or investing in pet projects.

Asymmetric information occurs when one party from a financial transaction has different information than the other.

The value of the firm can be computed by discounting the future expected cash flows with the cost of capital. Thus, the smaller the cost of capital,the greater the value of the firm. (Formula on p.52)

We call the mix of debt and equity that maximizes the value of the firm optimal capital structure.

Traditional approach assumes an optimal capital structure where theWACC is minimized and the value of the firm is maximized. The model suggests that up to a certain level of leverage, the use of debt financing reduces the WACC, but after that optimal level, the WACC escalates depressing the firm value.

Pecking order theory suggests that firms follow a hierarchy of funds in financing. Firstly, internal funds are exhausted by reinvesting the net income, and in raising external capital, debt is preferred over equity.

Franco Modigliani and Merton Miller (MM) are the founders of modern capital structure theory. Their first article (1958) is one of the most influential studies in academia.

WACC = 300/1200*0,16 + 900/1200*0,12*(1-0,25) = 0,1075 (10,75%)

Total Liabilites = 750,000-250,000= 500,000

WACC=(250,000/750,000)*0,17+(500,000/750,000)*0,14*(1-0.2) =13.3 %

The type of risk that is related to the uncertainty in the business operations of the firm is referred to as business risk.

According to the Trade-off Theory of capital structure theories, what does financial distress or bankruptcy costs refrain firms from abundant debt financ,ng, in other words, financial leverage.

WACC=wD*kD*(1-T)+wE*kE

0.15=0.5*kd*(1-0.25)+0.5*0.18

kd=0.16=16%

ROIC=NOPAT/Capital=EBIT*(1-T)/Capital

ROIC=400,000*(1-0.40)/1,400,000=0.1715=17.15%