(Which question are you asking yourself?

How did this cute little bird get lost in a

finance class?
Financial Structure
Dividend Policy
Skema – CFM Fall 2024
September 2024 - December 2024

Vincent Houtteville
Can you win the Nobel Prize with these?
Yes – if you happen to be a pair of
Smarties
Other required things to understand
financial structure
A Pot
A Tot
And (at least) one thing to understand dividend
policy
Who am I?
• Vincent Houtteville:
• Adjunct Faculty Member : Audencia, Edhec, Skema
Business Schools

• Auditor & Consultant: Financial audit, Evaluation,

business plan formulation @ LBA WALTER FRANCE

• Prior:
• Financial Analyst/Portfolio manager : New York &
London (~ 30 years, HSBC Asset Management, Janus
Henderson, Commonwealth Bank of Australia, Axa
Investments Management…)

• [email protected]
 Our ways of engagement: How to make it
work
Way # 1 : Anything you do not understand:
please ask
Way # 2 : Collaborate
Way # 3 : Provide feedback
Way # 4 : Take hand-written notes
Evaluation

• Final Exam: Multiple Choice

Questions
• Calculations
• Statements analysis (False/Correct,
least likely, most likely etc)
• Combination of the above
• 2 hours
• Which mark are you aiming for? Write
Evaluation

Example:
1. A firm is considering a significant capital expenditures programme. Its financing will require external
financing, as its existing cash is insufficient to finance the entirety of the programme. The current
debt/capital ratio is 25%, whilst the optimal level of debt financing, based on the Trade-Off-Theory is 40%.
This capex programme will increase the business risk of the firm. If this firm raises debt to finance this
programme, the optimal Debt/Capital ratio of the firm will:
a) Remain roughly unchanged
b) Tend to decline as the business risk is increasing, which in turn increases the bankruptcy risk
(reminder: even firms without debt can go bankrupt), hence reducing the amount of debt the firm
can bear
c) Increase because adding debt which is cheaper than equity and this will lower the WACC
d) None of the above.
Capital structure and dividend poilicy

What do you expect from this course?

 LEARNING OBJECTIVES

Handle real-life financial information to take

decisions
Understand Business risks and financial
risks
Understand Value creation and Financial
leverage
Frame a financing structure decision within
a theoretical context and a practical context
Frame a dividend policy in a theoretical
context and a practical context
 LEARNING THEMES

Theme 1: Risks, returns, financial leverage, value creation

Theme 2: Financial structure: Real life observations ; which

conclusions can be drawn?
Theme 3: Financial structure: From irrelevance to competing
theories
Theme 4: Financing decisions in practice
Theme 5: Dividend policy: the “dividend puzzle”: From
irrelevance to competing theories
Theme 6: Real life examples: Analysis of Nestle, Air Liquide
approaches
BONUS SESSION: Revision (1h)
CORPORATE FINANCE: MAXIMIZE THE VALUE OF
THE FIRM

Capital Capital Divide

Budgetin Structu nd Valuation
g re Policy
CORPORATE FINANCE: MAXIMIZE THE VALUE OF
THE FIRM

The The
The
financin distribut
investment
decision g ion
decision decision

Matchi
Cash Mix of
ng
flow & Hurdle equity
financi Size Form
Return rate and
ng &
s debt
assets
Financial data on US sectors &
Companies
Exercise : Rank the following US sectors from lowest Debt/Equity to highest Debt/Equity ratio; justify

• Basic Materials
• Capital Goods
• Conglomerates
• Consumer Discretionary
• Consumers Non cyclicals
• Energy
• Healthcare
• Retail
• Services
• Technology
• Transportation
• Utilities
Debt/Equity ratio for US Sectors: from lowest to highest
D/Equity ratio.
Debt/Equity ratio for US Sectors: from highest to lowest D/E ratio
Financial data on US sectors &
Companies

Financial structures ratios tend to be stable over time.

• What could be the reasons for this?

Assets & their Financing sources
Assets needed to run a business: INVESTED
CAPITAL
• Fixed assets: Tangible and Intangible assets
• Net Current assets: Inventories + Clients
Receivables – Suppliers Payables
• Cash: required to handle business frictions;
balance: available to pay down debt, invest in the
business and return money back to the equity holders

Financing Ressources: CAPITAL EMPLOYED

• A mix of Equity and debt  Financing
structure
 Measuring Operating Performance
RoCE: Return on Capital Employed

K
Equity
capital
EBIT EBIT
Capital (or
Operati RoCE
Employ
ngProfi
ed (CE) IC
t)
Financ or
ial CE
Debt
Is this life cycle approach to financial structure true in all cases?

Equity
capital

Assets
require
d to
run a
Assets Equity
busines
require capital
Assets s
d to run
require a Debt
d to Equity busines
run a capital s
busines
s Debt
Determining the Free Cash Flow to the
Firm (FCFF)

Lklk
 Funds providers have a claim
on the free cash generated:

• To pay interests and reimburse debt

(mandatory),

• To pay dividends (discretionary).

26
Financing sources

• Which one of the two suppliers of funds to a

firm is the most likely to lose its entire
investment?
• How is the equity provider remunerated?
• How is the debt provider remunerated?
• Which one of the two providers is better
remunerated?
• Are they always adequately remunerated?
Financing sources
Equity financing
• What do shareholders get in return:
• Ownership in the firm: influence, control over management
• Possibility to lose their entire investment in the firm
• A claim on the Earnings after tax
• Remuneration for the risks:
• Appreciation in value of the investment
• Dividends?

Borrowing (through Banks borrowing, bonds issuance,

commercial paper…)
• What do lenders get in return:
• Repayment of amounts lent to the firm
• Possibility to lose the entire amounts lent to the firm
• Remuneration for the risks:
• Contractual Interest payment on a regular basis (% of amount
outstanding)
Financing sources
• Which one of the two suppliers of funds to a firm is the most likely
to lose its entire investment?
• The equity financing provider:
• If the firm goes bankrupt, she will be the last to get something back
after liquidation (if there is anything left after all the creditors have
been paid)
• How is the equity provider remunerated? Increase in value of the
firm.
• How is the debt provider remunerated? Interests payment.
• Which one of the two providers is better remunerated? Is it the
right question to ask?
• Are they always adequately remunerated? No.

How do you determine the expected remuneration for the

risk taken?
• For the debt provider
• For the equity provider
How to price risk?
What is the fundamental mechanism used to price risk in Financial
Markets?
Kjkj
Pricing risk: Consider Risk free and Risk
Premium

Kjkj

What matters?
Rating agencies: S&P Summary ratings

jjjjjj
US Corporates – Cumulative Default rates by rating category

https://www.spglobal.com/ratings/en/research/articles/230613-default-transition-and-recovery-2022-
annual-u-s-corporate-default-and-rating-transition-study-12757422
Pricing risk: Consider Risk free and Risk
Premium

Kjkj

What matters?
Determining the cost of debt, using ratings

Go to : Skema Credit rating Exercice -CFM Fall

2024

• To do:

• Assume Risk-free rate of 1,55% for a US Firm

• Calculate the appropriate cost of debt for the

5 firms :
• Use only the EBIDTA/Interest Expenses ratio to determine
the cost of debt
• Use 1 decimal
 Determining the cost of debt, using ratings

Unlevered
Step 1 Levered Firm 1 Levered Firm 2 Levered Firm 3 Levered Firm 4
Firm
Equity 1 000,0 750,0 500,0 250,0 50,0
Debt 250,0 500,0 750,0 950,0
Kkk Employed
Capital 1 000,0 1 000,0 1 000,0 1 000,0 1 000,0
Cost of debt 2,50% 2,50% 2,50% 2,50% 2,50%
RoCE 12% 15% 12% 11% 7,0%

EBIT
Interest expenses
Earnings Before Tax

Depreciation 20,0 20,0 20,0 20,0 20,0

Ebitda (Ebit + Depreciation)

Interest coverage ratio (Ebitda/Int expenses)

Implied Credit rating from Interest coverage

Risk-free rate (a) 1,55% 1,55% 1,55% 1,55%

Spread over risk free rate (b)
Cost of debt to be charged
Rating agencies: S&P’s criteria
(Illustrative)

Llkk
LT debt rating AAA AA A BBB BB B CCC
Ebitda/Interest expenses (x) > 25.5 24.6 10.6 6.5 3.5 1.9 0.9
Free Cash Flows/Total Debt (%) > 127.6 44.5 25 17.3 8.3 2.8 -2.1
Total Debt/Ebitda (x) > 0.4 0.9 1.6 2.2 3.5 5.3 7.9
RoE (%) > 27.6 27 17.5 13.4 11.3 8.7 3.2

Spread over Risk free rate 0.63% 0.78% 1.08% 1.56% 2.40% 4.21% 8.20%
 Determining the cost of debt, using ratings

Unlevered
Step 1 Levered Firm 1 Levered Firm 2 Levered Firm 3 Levered Firm 4
Firm
Equity 1 000,0 750,0 500,0 250,0 50,0
Debt 250,0 500,0 750,0 950,0
Kkk Employed
Capital 1 000,0 1 000,0 1 000,0 1 000,0 1 000,0
Cost of debt 2,50% 2,50% 2,50% 2,50% 2,50%
RoCE 12% 15% 12% 11% 7,0%

EBIT
Interest expenses
Earnings Before Tax

Depreciation 20,0 20,0 20,0 20,0 20,0

Ebitda (Ebit + Depreciation)

Interest coverage ratio (Ebitda/Int expenses)

Implied Credit rating from Interest coverage

Risk-free rate (a) 1,55% 1,55% 1,55% 1,55%

Spread over risk free rate (b)
Cost of debt to be charged
Determining the cost of debt, using ratings

Unlevered
Step 1 Levered Firm 1 Levered Firm 2 Levered Firm 3 Levered Firm 4
Firm
Equity 1 000,0 750,0 500,0 250,0 50,0
Debt 250,0 500,0 750,0 950,0
Kkk
Capital Employed (CE = Equity + Debt) 1 000,0 1 000,0 1 000,0 1 000,0 1 000,0
Cost of debt 2,50% 2,50% 2,50% 2,50% 2,50%
RoCE 12,0% 15,0% 12,0% 11,0% 7,0%

EBIT (= RoCE x CE) 120,0 150,0 120,0 110,0 70,0

Interest expenses (debt x cost of debt) 0,0 6,3 12,5 18,8 23,8
Earnings Before Tax 120,0 143,8 107,5 91,3 46,3

Depreciation 20,0 20,0 20,0 20,0 20,0

Ebitda (Ebit + Depreciation) 140,0 170,0 140,0 130,0 90,0

Interest coverage ratio (Ebitda/Int expenses) -- 27,2 11,2 6,9 3,8

Implied Credit rating from Interest coverage AAA A BBB BB

Risk-free Rate 1,55% 1,55% 1,55% 1,55%

Spread over risk free rate (b) 0,63% 1,08% 1,56% 2,40%
Cost of debt to be charged = (a) + (b) 2,18% 2,63% 3,11% 3,95%
Determining the cost of debt, using ratings

Unlevered
Step 2 Levered Firm 1 Levered Firm 2 Levered Firm 3 Levered Firm 4
Firm
Equity 1 000,0 750,0 500,0 250,0 50,0
Debt 250,0 500,0 750,0 950,0
Kik
Capital Employed (CE) 1 000,0 1 000,0 1 000,0 1 000,0 1 000,0
Cost of debt (ratings-based)
RoCE 12% 15,0% 12,0% 11,0% 7,0%

Ebitda (Ebit + Depreciation) 0,0 0,0 0,0 0,0 0,0

Interest expenses 0,0 0,0 0,0 0,0

Interest coverage ratio (Ebitda/Int expenses)
Prior Credit rating
New Credit rating

Risk-free rate (a) 1,55% 1,55% 1,55% 1,55%

Prior Spread over risk free rate (b)
New Spread over risk free rate (c)
Prior Cost of debt
New Cost of debt
Determining the cost of debt, using ratings

Unlevered
Step 2 Levered Firm 1 Levered Firm 2 Levered Firm 3 Levered Firm 4
Firm
Equity 1 000,0 750,0 500,0 250,0 50,0
Debt 250,0 500,0 750,0 950,0
KikCapital Employed (CE) 1 000,0 1 000,0 1 000,0 1 000,0 1 000,0
Cost of debt (ratings-based from above)
RoCE 12% 15,0% 12,0% 11,0% 7,0%

Ebitda (Ebit + Depreciation) 0,0 0,0 0,0 0,0 0,0

Interest expenses 0,0 0,0 0,0 0,0

Interest coverage ratio (Ebitda/Int expenses)
Prior Credit rating
New Credit rating

Risk-free rate (a) 1,55% 1,55% 1,55% 1,55%

Prior Spread over risk free rate (b)
New Spread over risk free rate (c)
Prior Cost of debt
New Cost of debt
Determining the cost of debt, using ratings

Kik
Unlevered
Step 3 Levered Firm 1 Levered Firm 2 Levered Firm 3 Levered Firm 4
Firm
Adjustment based on Step 2
Prior Interest Coverage ratio
New Interest Coverage ratio
New debt rating
Prior debt rating
Credit spread
Cost of debt
Determining the cost of debt, using ratings

Unlevered
Step 2 Levered Firm 1 Levered Firm 2 Levered Firm 3 Levered Firm 4
Firm
Equity 1 000,0 750,0 500,0 250,0 50,0
Debt 250,0 500,0 750,0 950,0
Kkk
Capital Employed (CE) 1 000,0 1 000,0 1 000,0 1 000,0 1 000,0
Cost of debt (ratings-based, see above) 2,50% 2,18% 2,63% 3,11% 3,95%
RoCE 12% 15,0% 12,0% 11,0% 7,0%

Ebitda (Ebit + Depreciation) 140,0 170,0 140,0 130,0 90,0

Interest expenses (debt x cost of debt) 5,5 13,2 23,3 37,5

Interest coverage ratio (Ebitda/Int expenses) -- 31,2 10,6 5,6 2,4
Prior Credit rating AAA A BBB BB
New Credit rating AAA BBB BB B

Risk free rate (a) 1,55% 1,55% 1,55% 1,55%

Prior Spread over risk free rate (b) 0,63% 1,08% 1,56% 2,40%
New Spread over risk free rate (c) 0,63% 1,56% 2,40% 4,21%
Prior Cost of Debt = (a) + (b) 2,18% 2,63% 3,11% 3,95%
New Cost of debt = (a) + (c) 2,18% 3,11% 3,95% 5,76%
Determining the cost of debt, using ratings

Unlevered Levered
Step 3 Levered Firm 2 Levered Firm 3 Levered Firm 4
Firm Firm 1
Kkk
Adjustment based on Step 2
Prior Interest Coverage ratio 31,2 10,6 5,6 2,4
Prior debt rating AAA BBB BB B
New Interest Coverage ratio 31,2 9,0 4,4 1,6
New debt rating AAA BBB BB CCC
Credit spread 0,63% 1,56% 2,40% 8,20%
Cost of debt, from rating 0 2,18% 3,11% 3,95% 9,75%
Cost of debt: Using the Ratings
agencies approach
Exercise: “Skema Credit Rating Exercise – CFM Fall
2024”.
For Firm 4, at the end of Step 3:
1. Calculate the result of this firm (assume no tax)?
2. To reach break-even, what is the maximum amount of interest expenses it can bear?
3. What would be the maximum cost of debt at break-even?
4. When at break-even, which credit-rating would it get?
5. If Firm 4 aims for an improvement of its current credit rating to the next rating, which
amount of debt can it bear? (Clue: you will need to make an assumption).
6. Based on your findings for Question 5, calculate the new debt/equity ratio.
7. How much capital does Firm 4 need to raise to improve its rating?
8. How much capital does Firm 4 need to raise to improve its rating one step further?
Cost of debt: Using the Ratings agencies
approach
Solution for Exercise: “Impact of change in Credit Rating on financial structure”.

SOLUTION FOR EXERCISE "IMPACT OF CHANGE IN CREDIT RATING ON FINANCIAL STRUCTURE"

EBIT for firm 4 70,0

Interest expenses 92,6 (= 950 x 9,75%)
Pre-tax result -22,6

Maximum financial expenses for break even 70,0 (Ebit is 70, so for break even interest expenses can't be higher than 70)
Maximum Cost of debt at break even 7,37% (= 70/950)
Max credit Spread 5,82% (= 7,37% - 1.55%)

Implied Ebidta/Interext expense 1,29 (=90/70), rating is unchanged at CCC, as > 0.9 but < 1.9

==> Must tend towards > 1.9x coverage ratio, meaning towards a B rating
==> New cost of debt 5,76% (credit spread for a B rating + risk free = 4.21% + 1.55%)

Implied Interest expenses on 2x Coverage ratio 45,0 (Ebitda/2 = 90/2 = 45)

Implied debt (Implied interest expenses/Cost of debt) 781 (=45/5.76%)
% Debt, as % of total funding sources 78% (Debt/Capital Employed)
%Equity, as % of total funding sources 22% (100% -78%)

Debt/Equity 357% (We have debt: 781; we know capital employed is 1 000, so Equity = 1 000 - 781 = 219 ==> 781/219 = 357%)

Size of Capital raise 169 (= 950 -781)

Cost of debt: Using the Ratings
agencies approach
Exercise: “Impact of change in Credit Rating”.

For “Unlevered” Firm :

1. What would be the financial structure of this firm, if it chooses to borrow and
have a A rating?

1. If risk free is 1,55%?

2. If risk free is 4,5%?

3. Clue: you need to make an assumption…

Cost of debt: Using the Ratings
agencies approach
Exercise: “Impact of change in Credit Rating”.

For “Unlevered” Firm :

1. What would be the financial structure of this firm, if it chooses to borrow and have a A
rating? Situation 1 Situation 2

Coverage ratio (EBITDA/Interest expenses) 15 15

EBITDA 140 140
Interests expenses (EBITDA/Coverage ratio) 9,3 9,3

A rating Credit Spread 1,08% 1,08%

Risk free 1,55% 4,50%
Cost of debt 2,63% 5,58%

Amount of debt (interest expenses/cost of debt) 355 167

Amount of equity (1 000 - Debt) 645 833
 How to measure Financial risk?
Financial Risk = difficulty in meeting financial obligations at a certain
point in time; ultimately: Bankruptcy Risk

• 2 firms:
• For both: Ebitda: 100, FCFF: 50 and debt repayment: 30 p.a.
• Firm 1: Standard deviation of FCCF: 10,
• Firm 2: Standard deviation of FCFF: 30,
• Which one is the most exposed to Financial risk?
Interest cost: Risk free US Jan 2020: 1.92%; Oct
31/20: 0.88%

Hello
In times of stress: change in interest
costs

Kjkjk
Credit spreads in times of stress
Evolution of credit-spread with the rise of Covid-19
Risk free US Jan 2020: 1.92%; Oct
31/20: 0.88%

Lklk
Using the Ratings agencies approach
Starting point: The yield curve.
Using the Ratings agencies approach
Starting point: The yield curve
Using the Ratings agencies approach
Starting point: The yield curve
 How to measure Financial risk?

• How to assess (and price) Financial Risk :

• Use Ratings agencies approach
• Use the Z-score
• Build your own tool (credit analysis)
• Use Credit Default Swaps
• Use all of the above
Financial risk: Altman’s Z-score
(Source: Corporate Finance Institute)

Score to determine the probability of a firm becoming insolvent

Formula: Zeta = 1.2A + 1.4B + 3.3C + 0.6D + 1.0E (for US publicly traded
manufacturing companies)
With
• A: Working Capital/Total Assets
• B: Retained Earnings/Total Assets
• C: Earnings Before Interest and Tax/Total Assets
• D: Market Value of Equity/Total Liabilities
• E: Sales/Total Assets

If score < 1.8: high probability of insolvency

If score > 3: low probability of insolvency

In 2007, Altman’s Z-score was 1.81, leading Altman to believe that a crisis was very
likely.
How to measure Financial risk?
Financial Risk = Difficulty in meeting all financial obligations all the time; ultimately: Bankruptcy Risk

At stake:
• Payment of interest
• Reimbursement of principal

• How much debt?

• Gearing: Net Financial Debt/Total Equity

• Payment of interest?
• Ebitda/Financial expenses

• Repayment of principal?
• Net debt/Ebidta, Net debt/Free Cash Flow
The benefit of more debt

KEY RATIOS

• RoCE = Return on Capital Employed = Pre-tax Operating

Profit/Capital Employed
• After-tax RoCE = After-tax Operating Profit/Capital Employed

• RoE = Return on Equity = Net Profit/Equity

The benefit of more debt : Financial
Leverage
EXERCISE: Excel file “Skema Financial Leverage Exercise - CFM Fall 2024”
Assumptions: Capital Employed: 100; EBIT : 15; Interest Rate: 10%,
Tax rate: 0%

• Capital Structure 1: “Unlevered Firm”

• 100% Equity (10 shares)
• Capital Structure 2: “Levered Firm”
• 50% Equity/50% Borrowing (Equity: 5 shares)

• To Do:
• Calculate:
• Return on Equity for Capital Structure 1 and Capital Structure 2
• Return on Capital Employed for Capital Structure 1 and Capital Structure 2
• Calculate Earnings Per Share
• What do you observe?
Financial Leverage
Exercise: “Skema Financial Leverage Exercise - CFM Fall 2024”
Assumptions Unlevered Firm Levered Firm
Equity
Debt
Debt/Equity Ratio
Ebit
Interest rate
Tax rate
P&L and Returns
Ebit
Financial expenses
Earnings before tax
Tax
Earnings after Tax
RoCE
RoE (Return on Equity)

Number of shares
Earnings Per Share (EPS)

Which financial structure do you prefer?

Financial Leverage
Exercise: “Skema Financial Leverage Exercise - CFM Fall 2024”

Assumptions Unlevered Firm Levered Firm

Equity 100.0 50.0
Kjkj
Debt 0.0 50.0
Debt/Equity Ratio 0.0% 100.0%
Ebit 15.0 15.0
Interest rate 10.0% 10.0%
Tax rate 0% 0%
P&L and Returns
Ebit 15.0 15.0
Financial charges 0.0 5.0
Earnings before tax 15.0 10.0
Tax 0.0 0.0
Earnings after Tax 15.0 10.0
RoCE 15.00% 15.00%
RoE (Return on Equity) 15.00% 20.00%

Number of shares 10.0 5.0

Earnings Per Share (EPS) 1.5 2.0
Financial Leverage
Exercise: “Skema Financial Leverage Exercise - CFM Fall 2024”
Assumptions Unlevered Firm Levered Firm Unlevered Firm Levered Firm
Equity
Debt
Debt/Equity Ratio
Ebit 0,0 0,0
K
Interest rate 10,0% 10,0%
Tax rate 0% 0%
P&L and Returns
Ebit
Financial expenses
Earnings before tax
Tax
Earnings after Tax
RoCE
RoE (Return on Equity)

Number of shares 10,0 5,0

Earnings Per Share (EPS)

Which financial structure do you prefer??

 Financial Leverage
Exercise: “Skema Financial Leverage Exercise - CFM Fall 2024”

Assumptions Unlevered Firm Levered Firm Unlevered Firm Levered Firm

Equity 100,0 50,0 100,0 50,0
DebtK 0,0 50,0 0,0 50,0
Debt/Equity Ratio 0,0% 100,0% 0,0% 100,0%
Ebit 15,0 15,0 0,0 0,0
Interest rate 10,0% 10,0% 10,0% 10,0%
Tax rate 0% 0% 0% 0%
P&L and Returns
Ebit 15,0 15,0 0,0 0,0
Financial charges 0,0 5,0 0,0 5,0
Earnings before tax 15,0 10,0 0,0 -5,0
Tax 0,0 0,0 0,0 0,0
Earnings after Tax 15,0 10,0 0,0 -5,0
RoCE 15,00% 15,00% 0,00% 0,00%
RoE (Return on Equity) 15,00% 20,00% 0,00% -10,00%

Number of shares 10,0 5,0 10,0 5,0

Earnings Per Share (EPS) 1,5 2,0 0,0 -1,0
 Financial Leverage
Exercise: “Skema Financial Leverage Exercise - CFM Fall 2024”

Assumptions Unlevered Firm Levered Firm Unlevered Firm Levered Firm Levered Firm Levered Firm Levered Firm Levered Firm
Equity
Debt Kjkj
Debt/Equity Ratio
Ebit 0.0 0.0 5.0 12.5 15.0 20.0
Interest rate 10.0% 10.0% 10.0% 10.0% 10.0% 10.0% 10.0% 10.0%
Tax rate 0% 0% 0% 0% 0% 0% 0% 0%
P&L and Returns
Ebit 0.0 0.0 5.0 12.5 15.0 20.0
Financial expenses
Earnings before tax
Tax
Earnings after Tax
RoCE
RoE (Return on Equity)

Number of shares 10.0 5.0 10.0 5.0 5.0 5.0 5.0 5.0
Earnings Per Share (EPS)
 Financial Leverage
Assumptions Unlevered Firm Levered Firm Levered Firm Levered Firm Levered Firm Levered Firm Levered Firm
Equity 100.0 50.0 50.0 50.0 50.0 50.0 50.0
Debt 0.0 50.0 50.0 50.0 50.0 50.0 50.0
Debt/Equity Ratio 0.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0%
Ebit Kjkj 15.0 15.0 0.0 5.0 12.5 15.0 20.0
Interest rate 10.0% 10.0% 10.0% 10.0% 10.0% 10.0% 10.0%
Tax rate 0% 0% 0% 0% 0% 0% 0%
P&L and Returns
Ebit 15.0 15.0 0.0 5.0 12.5 15.0 20.0
Financial charges 0.0 5.0 5.0 5.0 5.0 5.0 5.0
Earnings before tax 15.0 10.0 -5.0 0.0 7.5 10.0 15.0
Tax 0.0 0.0 0.0 0.0 0.0 0.0 0.0
Earnings after Tax 15.0 10.0 -5.0 0.0 7.5 10.0 15.0
RoCE 15.00% 15.00% 0.00% 5.00% 12.50% 15.00% 20.00%
RoE (Return on Equity) 15.00% 20.00% -10.00% 0.00% 15.00% 20.00% 30.00%

Number of shares 10.0 5.0 5.0 5.0 5.0 5.0 5.0

Earnings Per Share (EPS) 1.5 2.0 -1.0 0.0 1.5 2.0 3.0
Financial Leverage
Levered Firm Levered Firm Levered Firm Levered Firm Levered Firm
Unlevered Firm Levered Firm Unlevered Firm
Assumptions Year 1 Year 2 Year 3 Year 4 Year 5
Equity 100,0 50,0 100,0 50,0 50,0 50,0 50,0 50,0
Debt 0,0 50,0 0,0 50,0 50,0 50,0 50,0 50,0
Debt/Equity Ratio 0,0% 100,0% 0,0% 100,0% 100,0% 100,0% 100,0% 100,0%
Kjkj
Ebit 15,0 15,0 0,0 0,0 5,0 12,5 15,0 20,0
Interest rate 10,0% 10,0% 10,0% 10,0% 10,0% 10,0% 10,0% 10,0%
Tax rate 0% 0% 0% 0% 0% 0% 0% 0%
P&L and Returns
Ebit 15,0 15,0 0,0 0,0 5,0 12,5 15,0 20,0
Financial charges 0,0 5,0 0,0 5,0 5,0 5,0 5,0 5,0
Earnings before tax 15,0 10,0 0,0 -5,0 0,0 7,5 10,0 15,0
Tax 0,0 0,0 0,0 0,0 0,0 0,0 0,0 0,0
Earnings after Tax 15,0 10,0 0,0 -5,0 0,0 7,5 10,0 15,0
RoCE 15,00% 15,00% 0,00% 0,00% 5,00% 12,50% 15,00% 20,00%
RoE (Return on Equity) 15,00% 20,00% 0,00% -10,00% 0,00% 15,00% 20,00% 30,00%

Number of shares 10,0 5,0 10,0 5,0 5,0 5,0 5,0 5,0
Earnings Per Share (EPS) 1,5 2,0 0,0 -1,0 0,0 1,5 2,0 3,0
Financial Leverage

• Which financial structure would you recommend?

• What could be wrong with this chart?
 Financial Leverage

Debt/Equity 0% 5% 10% 15% 20% 25% 30% 35% 40% 45% 50% 55% 60% 65% 70%
Equity 100,0 95,0 90,0 85,0 80,0 75,0 70,0 65,0 60,0 55,0 50,0 45,0 40,0 35,0 30,0
Debt 0,0 5,0 10,0 15,0 20,0 25,0 30,0 35,0 40,0 45,0 50,0 55,0 60,0 65,0 70,0
Ebit 15,0 15,0 15,0 15,0 15,0 15,0 15,0 15,0 15,0 15,0 15,0 15,0 15,0 15,0 15,0
Tax rate 0%
Interest rate 2,5% 2,5% 2,5% 2,5% 2,5% 2,5% 2,5% 2,5% 2,5% 2,5% 2,5% 2,5% 2,5% 2,5% 2,5%

P&L and Returns

Ebit 15,0 15,0 15,0 15,0 15,0 15,0 15,0 15,0 15,0 15,0 15,0 15,0 15,0 15,0 15,0
Financial charges 0,0 0,1 0,3 0,4 0,5 0,6 0,8 0,9 1,0 1,1 1,3 1,4 1,5 1,6 1,8
Egs before tax 15,0 14,9 14,8 14,6 14,5 14,4 14,3 14,1 14,0 13,9 13,8 13,6 13,5 13,4 13,3
Tax 0,0 0,0 0,0 0,0 0,0 0,0 0,0 0,0 0,0 0,0 0,0 0,0 0,0 0,0 0,0
Net Earnings 15,0 14,9 14,8 14,6 14,5 14,4 14,3 14,1 14,0 13,9 13,8 13,6 13,5 13,4 13,3

RoCE 15,00% 15,00% 15,00% 15,00% 15,00% 15,00% 15,00% 15,00% 15,00% 15,00% 15,00% 15,00% 15,00% 15,00% 15,00%
RoE 15,00% 15,66% 16,39% 17,21% 18,13% 19,17% 20,36% 21,73% 23,33% 25,23% 27,50% 30,28% 33,75% 38,21% 44,17%

• Which financial structure would you recommend? Impossible to answer

• To which extent could this chart be misleading? Cost of debt is unchanged. Possible
that at some point the interest expenses are greater than the operating income, the
firm being then loss-making.
Financial Leverage formula

RoE =
Post tax RoCE + (post tax RoCE – post tax cost of
Debt)*Debt/Equity

• Based only on this equation, when does the

relationship break down?
• Everything else equal, which operational
performance characteristic firms with high level
of debt should exhibit?
Financial Leverage formula

RoE =
Post tax RoCE + (post tax RoCE – post tax cost of
Debt)*Debt/Equity

• Based on this equation, when does the relationship

break down?
• When post-tax cost of debt > post-tax RoCE
• Everything else equal, which operational characteristic
firms with a high level of debt should exhibit?
• The higher the post-tax RoCE, the higher the quantity
of debt
Financial Leverage formula
RoE = RoCE (after-tax) + (RoCE – cost of debt after tax)*Debt/Equity
Assumptions Unlevered Firm Levered Firm
Equity 100.0 50.0
Debt 0.0 50.0
Debt/Equity Ratio 0.0% 100.0%
Ebit 15.0 15.0
Interest rate 10.0% 10.0%
Tax rate 25% 25%
P&L and Returns
Ebit 15.0 15.0
Financial charges 0.0 5.0
Earnings before tax 15.0 10.0
Tax 3.8 2.5
Earnings after Tax 11.3 7.5
RoCE 11.25% 11.25%
RoE (Return on Equity) 11.25% 15.00%
RoE Calc Check FS 1 FS 2
RoCE (A) 11.25% 11.25%
Net Cost of Debt (B) 7.50% 7.50%
Debt/Equity (C) 0.00% 100.00%
Leverage impact (D = (A - B)*C) 0.00% 3.75%
RoE (E = A + D) 11.25% 15.00%
 What are the two main
categories of risk faced by
a finance provider?
 What are the two main
categories of risk faced by a
finance provider?

• Financial risk
• Business risk
Business Risk

Two firms :

• Create a very simple exercise to illustrate different

level of business risk
Business Risk

Two firms : 1 operating in the US, the other in Europe

• USD/EUR = 0,94

• Firm 1: EBIT : $1 725 Mio, standard deviation of EBIT :

$172 Mio
• Firm 2: EBIT : €2 325 Mio, standard deviation of
EBIT : € 279 Mio
• Which one is the riskiest?

• Firm 2: STDEV of EBIT (as % of EBIT) = 12% vs. 10% for Firm 1
Business Risk

What are the 4 main sources of business risk ?

Business Risk

What are the 4 main sources of business risk

• Cyclicality of the business: dependence of the

economic cycle
• Industry dynamics: competitive intensity
• Competitive position of the firm
• Degree of operational leverage : fixed costs vs.
variable costs
Business risks:
The sources of Business Risks: Industry and company-specifics features

HEALTHCARE (Sanofi); Go to Pages 1 and following of this document :

Form 20F 2023:

STEEL INDUSTRY (Arcelor Mittal); Go to pages 15 and following of this

document : Form 20F 2023:

• TO DO: For each firm:

• Identify 3 risks which affect all firms in the respective
industries,
• Identify 3 risks which are specific to each company
• Which firm do you think is the riskiest, solely from a
business perspective?
How to price risk from the
perspective of an equity
provider?
 What are the two main
categories of risk faced by a
finance provider?

• Financial risk
• Business risk
Pricing risk: Risk free and risk premium

Kjkj

What matters?
Pricing risk: Risk free and risk premium
How to determine the risk premium? (clue:
using historical data).

An Equity investor would expect a return

commensurate to the risk of owning specific
shares vs. “owning the market”.
• If the shares are riskier than the
market : expected return >
Market Return.
• If the shares are less risky than
the market : expected return <
Market Return.
Observation of βeta
βeta : Regression ; Covariance
 What does eta capture?
Assuming that the equity market represents the broader economy and the average financial
structure of all firms, the eta captures the situation of a firm in relation to the market as far
as its value is concerned:

• eta captures:
• The impact of the firm’s industry on its cash flows (degree of
cyclicality)
• The impact of its costs structure (degree of operating leverage)
• The impact of a firm’s financial structure (degree of reliance on debt
funding)

 Beta captures both Financial Risk and Business Risk

Cost of Equity: The role of eta

The higher the

Financial
debt, the higher
leverage
the βeta

The higher the Beta of

Macro Equity
dependency on
environm Macro leverage
the economy, the (levered
ent βeta)
higher the βeta

The higher the %

Operating
leverage of fixed costs, the
higher the βeta

87
 Expected remuneration of an equity provider
=
Expected Equity Return
=
Cost of Equity
=
Risk Free + βeta x Market Risk Premium
With Market Risk Premium = Market Return – Risk free

88
How to put everything
together?
Corporate Finance: Value
maximization

How to value a firm?

Corporate Finance: Value maximization

Who said: ‘‘A fool is someone who knows the price of

everything,
And the value of nothing”?
Warren Buffet, Donald Trump, Elon Musk, Oscar Wilde?

What is value?
Does the price of an asset reflect its value?

How do you determine the value of a

firm?
Corporate Finance: Value
maximization

How to value a firm?

• “Intrinsic” valuation method: Discounting

Cash Flows

• “Relative” valuation method: Using

Comparables

We will only use the “Intrinsic”

Determining the Free Cash Flow to the
Firm (FCFF)

Lklk

Who has a claim on the FCFF?

Corporate Finance: Value
maximization

FCFF = FREE CASH FLOWS to the

FIRM :

Cash available to Lenders and Shareholders after financing

growth
Corporate Finance: Value
maximization

FCFF = FREE CASH FLOWS to the

FIRM :

Cash available to Lenders and Shareholders after financing

growth

Which remuneration do Shareholders expect?

How to calculate the remuneration expected by
Shareholders?
Corporate Finance: Value
maximization
Value of the firm =
Discounted Free cash flows to the Firm (FCFF) =

With FCFF = FREE CASH FLOWS to the FIRM: Cash available

to equity holders and debt holders after financing growth

How to determine the discount rate?

Corporate Finance: Value maximization
Value of the firm =
Discounted Free cash flows to the Firm (FCFF) =

Discount rate reflecting the expected returns to remunerate :

• the riskiness of the operating business,
• the riskiness of the financial structure put in place to support
the business,
• From the combined perspectives of the shareholders and
lenders.
 Discount rate is the Weighted Average Cost of Capital

What is the WACC of a firm which has no debt?

Corporate Finance: Value maximization

Value of the firm =

Discounted Free cash flows to the Firm (FCFF) =

 Formula for Weighted Average Cost of Capital

WACC = CoE x Equity/V + post-tax CoD x Debt/V

= Re x Equity/Firm Value + Rd x Debt/Firm Value

With V = Value of Equity + Value of Debt, at market value

In practice : Equity valued at Market value, Debt valued at Book value

99
Corporate Finance: Value maximization

Value of the firm =

Discounted Free Cash Flows to the Firm (FCFF) =

By simplification, we will assume that FCFF grows in

perpetuity at the same rate, called g.
Then: Value of the firm =
FCFF/(WACC – g)
Determining the Free Cash Flow to the
Firm

Lklk
Determining the value of the firm and of the
equity

Lklklklk
How to improve the value of the firm?

Klkk
 WEIGHTED AVERAGE COST OF CAPITAL

When debt increases as a % of the total financing sources:

• Does the cost of debt increase?

• Does the cost of equity increase?

104
WEIGHTED AVERAGE COST OF CAPITAL

• When debt rises, debt becomes riskier  Cost of Debt increases.

• When debt rises, equity becomes riskier  Cost of Equity

increases.

 What happens to the WACC?

 Does it increase also?

105
 WEIGHTED AVERAGE COST OF CAPITAL

When debt increases as a % of the total financing sources of

the firm, what happens to the WACC?
• When debt rises, debt becomes riskier  Cost of Debt increases.
• When debt rises, equity becomes riskier  Cost of Equity increases.

 Need to study the interaction between the changes in the

cost of Equity and the cost of Debt and the changes in the
financial structure

106
 WEIGHTED AVERAGE COST OF CAPITAL

To determine the impact of the evolution of the financial

structure on the WACC of a firm :

• Calculate the cost of Debt for any financial structure

• Calculate the cost of Equity for any financial structure:

 Calculate the ‘‘unlevered’’ βeta

(also called ‘‘Asset’’ βeta or ‘‘Activity’’ βeta)

107
 WEIGHTED AVERAGE COST OF CAPITAL

Formula to calculate the “Unlevered” eta:

Unlevered company = company / [1 + (1 – TC) * (VD/VE)cpy]
With TC = Tax-rate ; VD = Value of Debt: ; VE = Value of Equity

Formula to “releverage” eta:

Levered company = Unlevered company x [1 + (1 – TC)
(VD/VE)cpy]
(HAMADA FORMULA – 1972)

108
COST OF EQUITY CALCULATION
Go to : SKEMA Unlevered and relevered Betas - CFM Fall 2024
• Go to : SKEMA Unlevered and relevered Betas - CFM Fall
2024
Calculate unlevered Beta for each company in the sample below:

Unlevered company = company / [1 + (1 – TC)

Tax rate 25%
* (VD/VE)cpy]
Debt/Equity Unlevered
Company Beta
Ratio beta

Company A 1.15 34.0% 0.92

Company B 0.92 0.0% 0.92
Company C 2.25 75.0% 1.44
Company D 1.05 35.0% 0.83
Company E 0.91 11.0% 0.84
Average 1.26 31.0% 0.99
110
Calculate unlevered Beta for each company in the sample below:

Unlevered company = company / [1 + (1 – TC)

* (VD/VE)cpy]
Tax rate 25%

Debt/Equity Unlevered
Company Beta
Ratio beta

Company A 1.15 34.0% 0.92

Company B 0.92 0.0% 0.92
Company C 2.25 75.0% 1.44
Company D 1.05 35.0% 0.83
Company E 0.91 11.0% 0.84
Average 1.26 31.0% 0.99
111
Calculate new Beta after change in the capital structure (Vd/Ve)

Levered Beta formula: Levered company = Unlevered company [1 + (1 – TC)

(VD/VE)cpy]
Target
Beta Debt/Equity Unlevered Debt/Equity New Beta
Ratio Beta ratio
Company A 1,15 34% 34%
Company B 0,92 0% 34%
Company C 2,25 75% 20%
Company D 1,05 35% 0%
Company E 0,91 11% 35%
Average

112
Calculate new Beta after change in the capital structure (Vd/Ve)

Levered Beta formula: Levered company = Unlevered company [1 + (1 –

TC) (VD/VE)cpy]

Tax rate 25%

Debt/Equity Unlevered
Company Beta Target D/E New Beta
Ratio beta

Company A 1.15 34.0% 0.92 34.0% 1.15

Company B 0.92 0.0% 0.92 34.0% 1.15
Company C 2.25 75.0% 1.44 20.0% 1.66
Company D 1.05 35.0% 0.83 0.0% 0.83
Company E 0.91 11.0% 0.84 35.0% 1.06
Average 1.26 31.0% 0.99 24.6% 1.17

113
Calculate Levered eta for Debt/Capital varying from 0% to 90%

Levered company = Unlevered company [1 + (1 – TC) (VD/VE)cpy]

Unlevered Beta 1,2
Tax rate 25%

Debt/Total Debt/Equity Levered

Capital ratio Beta
0%
10,0%
20,0%
30,0%
40,0%
50,0%
60,0%
70,0%
80,0%
90,0% 114
Calculate Levered eta for Debt/Capital varying from 0% to 90%

Unlevered Beta 1.2

Tax rate 25.0%
Assuming :
Debt/Total Capital Debt/Equity Ratio Leveraged Beta

Risk Free: 3% 0% 0% 1.20

10% 11% 1.30
Market Risk Premium : 6% 20% 25% 1.43
30% 43% 1.59
40% 67% 1.80
50% 100% 2.10

Calculate the Cost of Equity. 60%

70%
150%
233%
2.55
3.30
80% 400% 4.80
90% 900% 9.30
Calculate Levered eta for Debt/Capital varying from 0% to 90%

Assuming :
Debt/Total Debt/Equity Levered Cost of
Capital ratio Beta Equity
0% 0% 1,2 10%
Risk Free: 3% 10,0% 11% 1,3 11%
20,0% 25% 1,4 12%
Market Risk Premium : 6% 30,0% 43% 1,6 13%
40,0% 67% 1,8 14%
50,0% 100% 2,1 16%
60,0% 150% 2,6 18%
Calculate the Cost of Equity. 70,0% 233% 3,3 23%
80,0% 400% 4,8 32%
90,0% 900% 9,3 59%
Calculate Levered eta for Debt/Capital varying from 0% to 90%

Levered company = Unlevered company [1 + (1 – TC) (VD/VE)cpy]

WACC: change in financial structure, impact
on value
Exercise : Build a table to calculate the value of a firm generating €1 Mio of FCFF
depending on the financial structure of the firm (from debt/Total capital = 0% to
50%).

Guidance:
• Which data do you need?
• Organize your key data in columns:
• Your first column is for evolution of the Debt/Total capital ratio
• Create a column for each of the major steps of the calculation

• What do you observe? What can you conclude?

WACC: change in financial structure, impact
on value
• Exercise: Skema Valuation Exercise - CFM Fall 2024
• Build a table to calculate the value of a firm generating € 1 Mio of FCFF depending on the financial structure of the firm
(from debt/Total capital = 0% to 50%).

Unlevered Beta 1,8 US Risk Free 3,50%

Eq Risk
Tax rate 35,0% 6,00%
Premium

Value of 1
Cost of Change in
Debt/Equity Credit Credit Cost of Perpetuity Mio € of
Debt/Total Capital Levered Beta Cost of Equity Debt, net WACC value vs.
Ratio Rating Spread Debt growth FCFF in
of tax unlevered
perpetuity
0% AAA 0,76% 0,0% 2,0%
10% 11% AA 0,86% 0,0% 2,0%
20% 25% A 1,19% 0,0% 2,0%
30% 43% A- 1,34% 0,0% 2,0%
40% 67% BBB 1,81% 0,0% 2,0%
50% 100% BB 2,32% 0,0% 2,0%
WACC: change in financial structure, impact
on value
• Exercise : Skema Valuation Exercise - CFM Fall 2024
• Build a table to calculate the value of a firm generating € 1 Mio of FCFF depending on the financial structure of the firm
(from debt/Total capital = 0% to 50%).

Unlevered Beta 1,8 US Risk Free 3,50%

Eq Risk
Tax rate 35,0% 6,00%
Premium

Value of 1
Cost of Change in
Debt/Equity Levered Credit Credit Cost of Perpetuity Mio € of
Debt/Total Capital Cost of Equity Debt, net WACC value vs.
Ratio Beta Rating Spread Debt growth FCFF in
of tax Unlevered
perpetuity
0% 0% 1,80 14,3% AAA 0,76% 4,26% 2,8% 14,3% 2,0% 8,13 0,0%
10% 11% 1,93 15,1% AA 0,86% 4,36% 2,8% 13,9% 2,0% 8,43 3,8%
20% 25% 2,09 16,1% A 1,19% 4,69% 3,0% 13,5% 2,0% 8,73 7,4%
30% 43% 2,30 17,3% A- 1,34% 4,84% 3,1% 13,1% 2,0% 9,04 11,2%
40% 67% 2,58 19,0% BBB 1,81% 5,31% 3,5% 12,8% 2,0% 9,29 14,2%
50% 100% 2,97 21,3% BB 2,32% 5,82% 3,8% 12,6% 2,0% 9,48 16,6%
WACC: change in financial structure, impact
on value
• Exercise: Skema Valuation Exercise - CFM Fall 2024
• Build a table to calculate the value of a firm generating € 1 Mio of FCFF depending on the financial structure of the firm
(from debt/Total capital = 50% to 90%).

Unlevered Beta 1,8 US Risk Free 3,50%

Eq Risk
Tax rate 35,0% 6,00%
Premium

Value of 1
Cost of Change in
Debt/Equity Credit Credit Cost of Perpetuity Mio € of
Debt/Total Capital Levered Beta Cost of Equity Debt, net WACC value vs.
Ratio Rating Spread Debt growth FCFF in
of tax unlevered
perpetuity
0% AAA 0,76% 0,0% 2,0%
10% 11% AA 0,86% 0,0% 2,0%
20% 25% A 1,19% 0,0% 2,0%
30% 43% A- 1,34% 0,0% 2,0%
40% 67% BBB 1,81% 0,0% 2,0%
50% 100% BB 2,32% 0,0% 2,0%
60% 150% B 8,25% 0,0% 2,0%
70% 233% CCC 11,75% 0,0% 2,0%
80% 400% CC 12,38% 0,0% 2,0%
90% 900% D 21,26% 0,0% 2,0%
WACC: change in financial structure, impact
on value
• Exercise:

Unlevered Beta 1,8 US Risk Free 3,50%

Eq Risk
Tax rate 35,0% 6,00%
Premium

Value of 1
Cost of Change in
Debt/Equity Levered Credit Credit Cost of Perpetuity Mio € of
Debt/Total Capital Cost of Equity Debt, net WACC value vs.
Ratio Beta Rating Spread Debt growth FCFF in
of tax Unlevered
perpetuity
0% 0% 1,80 14,3% AAA 0,76% 4,26% 2,8% 14,3% 2,0% 8,13 0,0%
10% 11% 1,93 15,1% AA 0,86% 4,36% 2,8% 13,9% 2,0% 8,43 3,8%
20% 25% 2,09 16,1% A 1,19% 4,69% 3,0% 13,5% 2,0% 8,73 7,4%
30% 43% 2,30 17,3% A- 1,34% 4,84% 3,1% 13,1% 2,0% 9,04 11,2%
40% 67% 2,58 19,0% BBB 1,81% 5,31% 3,5% 12,8% 2,0% 9,29 14,2%
50% 100% 2,97 21,3% BB 2,32% 5,82% 3,8% 12,6% 2,0% 9,48 16,6%
60% 150% 3,56 24,8% B 8,25% 11,75% 7,6% 14,5% 2,0% 7,99 -1,7%
70% 233% 4,53 30,7% CCC 11,75% 15,25% 9,9% 16,1% 2,0% 7,07 -13,0%
80% 400% 6,48 42,4% CC 12,38% 15,88% 10,3% 16,7% 2,0% 6,79 -16,5%
90% 900% 12,33 77,5% D 21,26% 24,76% 16,1% 22,2% 2,0% 4,94 -39,2%
WACC: change in financial structure, impact
on value
• Exercise: Based on previous work

• Draw a chart of the evolution of the value of the firm as a function of a change in the
financial structure (Debt/Total Capital)

• Draw a chart of the evolution of the WACC as a function of a change in the financial
structure (Debt/total Capital)
WACC: change in financial structure, impact
on value
• Exercise:
Draw a chart of the evolution of the value of the firm as a function of a change in the financial structure
WACC: change in financial structure, impact
on value
• Exercise:
Draw a chart of the evolution of the WACC as a function of a change in the financial structure
WACC: change in financial structure, impact
on value

• Exercise: Based on the previous charts

Which financial structure would you recommend for this firm?

Troubles on the horizon?
WACC: change in financial structure, impact
on value

What happens to a business in times of rising financial

stress?
WACC: change in financial structure, impact
on value
• Does Financial (di)stress have a cost?
• Indirect costs :

• Loss of productivity : RoCE declines  Less FCFF for the same amount of CE
• Loss of business : RoCE declines  Less FCFF for the same amount of CE
• Loss of growth opportunity

• Direct costs :

• All the fees related to management of the financial distress/bankruptcy process (lawyers,
administrators, consultants etc)
• Restructuring cost, lay-offs costs
• Sale of assets at distressed prices

 Cost of Bankruptcy risk = Severity of Bankruptcy x Probability of

Bankruptcy
 WACC: change in financial structure, impact
on value
• Exercise: Fill the table below for all the financial structures below and calculate the value of the firm including
Bankruptcy costs
• Assumptions:
• If Debt/Total Capital reaches 60%, the FCFF is reduced by 20% and the perpetuity growth rate falls to 0%
• Calculate the value of the firm and the value of the equity of the firm.
• Which financial structure would you recommend?

Unlevered Beta 1,8 US Risk Free 3,50% Rising Financial stress

Eq Risk
Tax rate 35,0% 6,00% FCFF = 0,8 Mio and g = 0%
Premium

Value of 1
Cost of
Debt/Equity Levered Credit Credit Cost of Perpetuity Mio € of Value of the Value of
Debt/Total Capital Cost of Equity Debt, net WACC
Ratio Beta Rating Spread Debt growth FCFF in firm the equity
of tax
perpetuity
0% 0% 1,80 14,3% AAA 0,76% 4,26% 2,8% 14,3% 2,0% 8,13
10% 11% 1,93 15,1% AA 0,86% 4,36% 2,8% 13,9% 2,0% 8,43
20% 25% 2,09 16,1% A 1,19% 4,69% 3,0% 13,5% 2,0% 8,73
30% 43% 2,30 17,3% A- 1,34% 4,84% 3,1% 13,1% 2,0% 9,04
40% 67% 2,58 19,0% BBB 1,81% 5,31% 3,5% 12,8% 2,0% 9,29
50% 100% 2,97 21,3% BB 2,32% 5,82% 3,8% 12,6% 2,0% 9,48 4,74
60% 150% 3,56 24,8% B 8,25% 11,75% 7,6% 14,5% 2,0% 7,99 5,51 0,77
70% 233% 4,53 30,7% CCC 11,75% 15,25% 9,9% 16,1% 2,0% 7,07 4,96 0,22
80% 400% 6,48 42,4% CC 12,38% 15,88% 10,3% 16,7% 2,0% 6,79 4,78 0,04
90% 900% 12,33 77,5% D 21,26% 24,76% 16,1% 22,2% 2,0% 4,94 3,60 -1,14
 WACC: change in financial structure, impact
on value
• Exercise: Fill the table below for all the financial structures below and calculate the value of the firm
• Assumptions:
• If Debt/Total Capital reaches 60%, the FCFF is reduced by 20% and the perpetuity growth rate falls to 0%
• Calculate the value of the firm and the value of the equity of the firm.
• Which financial structure would you recommend?
Unlevered Beta 1,8 US Risk Free 3,50% Rising Financial stress
Market Risk
Tax rate 35,0% 6,00% FCFF = 0,8 Mio and g = 0%
Premium

Value of 1
Cost of Change in
Debt/Equity Levered Credit Credit Cost of Perpetuity Mio € of Value of the Value of the
Debt/Total Capital Cost of Equity Debt, net WACC value vs.
Ratio Beta Rating Spread Debt growth FCFF in firm equity
of tax Unlevered
perpetuity
0% 0% 1,80 14,3% AAA 0,76% 4,26% 2,8% 14,3% 2,0% 8,1 0,0% 8,1
10% 11% 1,93 15,1% AA 0,86% 4,36% 2,8% 13,9% 2,0% 8,4 3,8% 8,4
20% 25% 2,09 16,1% A 1,19% 4,69% 3,0% 13,5% 2,0% 8,7 7,4% 8,7
30% 43% 2,30 17,3% A- 1,34% 4,84% 3,1% 13,1% 2,0% 9,0 11,2% 9,0
40% 67% 2,58 19,0% BBB 1,81% 5,31% 3,5% 12,8% 2,0% 9,3 14,2% 9,3
50% 100% 2,97 21,3% BB 2,32% 5,82% 3,8% 12,6% 2,0% 9,5 16,6% 9,5 4,74
60% 150% 3,56 24,8% B 8,25% 11,75% 7,6% 14,5% 2,0% 8,0 -1,7% 5,5 0,77
70% 233% 4,53 30,7% CCC 11,75% 15,25% 9,9% 16,1% 2,0% 7,1 -13,0% 5,0 0,22
80% 400% 6,48 42,4% CC 12,38% 15,88% 10,3% 16,7% 2,0% 6,8 -16,5% 4,8 0,04
90% 900% 12,33 77,5% D 21,26% 24,76% 16,1% 22,2% 2,0% 4,9 -39,2% 3,6 -1,14
 WACC: change in financial structure, impact
on value
• Exercise: Fill the table below for all the financial structures below and calculate the value of the firm
• Assumptions:
• If Debt/Total Capital reaches 60%, the FCFF is reduced by 20% and the perpetuity growth rate falls to 0%
• Calculate the value of the firm and the value of the equity of the firm.
• Which financial structure would you recommend?

Unlevered
1,8 US Risk Free 3,50%
Beta Rising Financial stress
Market Risk
Tax rate 35,0% 6,00% FCFF = 0,8 Mio and g = 0%
Premium

Value of 1 Value of the

Cost of Change in Value of the
Debt/Total Debt/Equity Levered Credit Credit Cost of Perpetuity Mio € of firm = Value
Cost of Equity Debt, net WACC value vs. equity (= FV - Debt
Capital Ratio Beta Rating Spread Debt growth FCFF in of Equity +
of tax Unlevered Debt)
perpetuity Debt)
0% 0% 1,80 14,3% AAA 0,76% 4,26% 2,8% 14,3% 2,0% 8,1 0,0% 8,1
10% 11% 1,93 15,1% AA 0,86% 4,36% 2,8% 13,9% 2,0% 8,4 3,8% 8,4
20% 25% 2,09 16,1% A 1,19% 4,69% 3,0% 13,5% 2,0% 8,7 7,4% 8,7
30% 43% 2,30 17,3% A- 1,34% 4,84% 3,1% 13,1% 2,0% 9,0 11,2% 9,0
40% 67% 2,58 19,0% BBB 1,81% 5,31% 3,5% 12,8% 2,0% 9,3 14,2% 9,3
50% 100% 2,97 21,3% BB 2,32% 5,82% 3,8% 12,6% 2,0% 9,5 16,6% 9,5 4,7 4,7
60% 150% 3,56 24,8% B 8,25% 11,75% 7,6% 14,5% 2,0% 8,0 -1,7% 5,5 0,8 4,7
70% 233% 4,53 30,7% CCC 11,75% 15,25% 9,9% 16,1% 2,0% 7,1 -13,0% 5,0 0,2 4,7
80% 400% 6,48 42,4% CC 12,38% 15,88% 10,3% 16,7% 2,0% 6,8 -16,5% 4,8 0,0 4,7
90% 900% 12,33 77,5% D 21,26% 24,76% 16,1% 22,2% 2,0% 4,9 -39,2% 3,6 -1,1 4,7
WACC : Change on financial structure,
impact on value
Impact of increasing debt on the value of the firm

• Adding debt lowers the WACC, up to a point

• The closer to the optimal WACC, the higher the cost of Bankruptcy risk.
• The higher the cost of bankruptcy risk, the lower the valuation of the firm.
• Beware: higher probability of bankruptcy will be anticipated, so value of the firm will be affected
before the financial stress actually occurs.

Decision about financial structure needs to take into account the cost of
bankruptcy risk in a broader sense than increase in cost of Equity and cost of
debt.
This cost of bankruptcy risk varies from sector to sector, and from firm to firm.
To get or not to get it.
 Change in financial structure, impact on
value

What does a business need in times of significant investment opportunities?

 Change in financial structure, impact on
value
Use of debt to make an acquisition

What are the steps to consider?

 Change in financial structure, impact on
value
Use of debt to make an acquisition

What are the steps to consider?

• Is the target attractive?

• Is the acquirer fairly valued?
• What are the financial consequences of the acquisition?
 Change in financial structure, impact on
value
Use of debt to make an acquisition
What are the steps to consider?
Target Acquirer Combined Firm
Excel File: Skema – Acquisition Debt and value of the firm – Students CFM 2024
Beta 2 1,30
Market Value of Equity 9 500 € 47 087 €
Debt 9 500 € 0€
CoE
Cost of debt, after tax Value of Firm 19 000 € 47 087 €
WACC D/E Ratio 100,00% 0,00%
Valuation work Tax Rate 30% 30%
Estimated Value of the firm
Estimated Value of the Equity
Unlevered Beta
Change in value of Equity
Market Value of Equity 9 500 €
Cost of debt 5,00% 3,27%
Upside/(downside) -100%
Tax rate 30% 30% 30%

EBIT 2 000 € 3 000 €

FCFF 1 400 € 2 425 €
FCFF Growth in perpetuity 2,00% 3,00%
 Change in financial structure, impact on
value
Use of debt to make an acquisition Impact of an acquisition on the value of the Acquirer

Step 1: Is the target attractive? Beta

Target
2
Acquirer Combined Firm
1,30
Market Value of Equity 9 500 € 47 087 €
Debt 9 500 € 0€
Excel File: Skema – Acquisition Debt and value of the firm – Students CFM 2023 Value of Firm 19 000 € 47 087 €
D/E Ratio 100,00% 0,00%
Tax Rate 30% 30%
Unlevered Beta

Cost of debt 5,00% 3,27%

CoE
Tax rate 30% 30% 30%
Cost of debt, after tax
WACC
EBIT 2 000 € 3 000 €
Valuation work FCFF 1 400 € 2 425 €
Growth in perpetuity 2,00% 3,00%
Estimated Value of the firm
Estimated Value of the Equity
Acquisition at Market value financed by debt
Change in value of Equity
Market Value of Equity 9 500 €
Acquisition Cost 9 500 €
Upside/(downside) -100%
New Debt Issued 9 500 €
New Equity Issued 0€
 Change in financial structure, impact on
value
Use of debt to make an acquisition Impact of an acquisition on the value of the Acquirer

Step 1: Is the target attractive? Beta

Target
2
Acquirer Combined Firm
1,30
Market Value of Equity 9 500 € 47 087 €
Debt 9 500 € 0€
Excel File: Skema – Acquisition Debt and value of the firm – Students CFM 2024 Value of Firm 19 000 € 47 087 €
D/E Ratio 100,00% 0,00%
Tax Rate 30% 30%
Unlevered Beta

Cost of debt 5,00% 3,27%

CoE
Tax rate 30% 30% 30%
Cost of debt, after tax
WACC
EBIT 2 000 € 3 000 €
Valuation work FCFF 1 400 € 2 425 €
Growth in perpetuity 2,00% 3,00%
Estimated Value of the firm
Estimated Value of the Equity
Acquisition at Market value financed by debt
Change in value of Equity
Market Value of Equity 9 500 €
Acquisition Cost 9 500 €
Upside/(downside) -100%
New Debt Issued 9 500 €
New Equity Issued 0€
 Change in financial structure, impact on
value
Use of debt to make an acquisition

Step 1: Is the target attractive?

CoE 12,0%
Cost of debt, after-tax 3,5%
WACC 7,8%

Valuation work
Estimated Value of the firm 24 348 €
Estimated Value of the Equity 14 848 €
Change in value of Equity
Market Value of Equity 9 500 €
Upside 56%

Based on data above, the target appears to be significantly undervalued.

 Change in financial structure, impact on
value
Use of debt to make an acquisition

Step 2 : Is the acquirer fairly valued (acquirer with 0 leverage)?

Valuation work
Target Acquirer
Estimated Value of the firm 24 348 € 47 087 €
Estimated Value of the Equity 14 848 € 47 087 €
Change in value of Equity
Market Value of Equity 9 500 € 47 087 €
Upside/(downside) 56% 0%

The acquirer appears to be fairly valued.

Change in financial structure, impact on
value
Use of debt to make an acquisition

Step 3 : Estimate impact of acquisition on value of the Acquirer.

(Acquirer with 0 leverage)
Acquisition price : 9 500

What will change as a consequence of the acquisition?

• …
• …

• …
Change in financial structure, impact on
value
Use of debt to make an acquisition : Estimate impact on value of the Acquirer (0 leverage)

What will change as a consequence of the acquisition?

• Unlevered Beta Target Acquirer Combined Firm

Beta 2 1,30
• Financial structure Market Value of Equity 9 500 € 47 087 €
Debt 9 500 € 0€
• Beta
Value of Firm 19 000 € 47 087 €
• Quantity of EBIT and FCFF D/E Ratio 100,00% 0,00%
Tax Rate 30% 30%
• Perpetuity growth rate Unlevered Beta 1,18 1,30 1,251 = Weighted average, using EBIT
• Cost of debt
Cost of debt 5,00% 3,27% Provided
• Cost of Equity Tax rate 30% 30% 30% = Weighted Average
• RoCE
EBIT 2 000 € 3 000 € 5 000 € = Sum
FCFF 1 400 € 2 425 € 3 825 € = Sum
FCFF Growth in perpetuity 2,00% 3,00% 2,63% = Weighted Average growth

• Will the Board approve this transaction?

Change in financial structure, impact on
value
Use of debt to make an acquisition : estimate impact on value of the Acquirer (0 leverage)
Target Acquirer Combined Firm
Equity 47 087 € 47 087 € Only known value
What will change as a consequence of the acquisition? Debt 0€ 19 000 € Debt of Target + Debt raised for the deal
• Unlevered Beta Total Funding 66 087 € = Equity + Debt
• Financial structure New D/E Ratio 40% Based on values above
• Beta New Beta 1,60 = Unlevered Beta x [1+(1 - tax rate) x D/E]
• Quantity of EBIT and FCFF CoE 12,0% 8,2% 9,8% = Rf + Beta x Market Risk Premium
• Perpetuity growth rate Cost of debt, after tax 3,5% 0,0% 2,3% Based on values above
• RoCE WACC 7,8% 8,2% 7,7%

Valuation work
Target Acquirer Combined Firm
Estimated Value of the firm 24 348 € 47 087 € 76 183 € = FCFF/(New WACC - new perpetuity growth rate)
Estimated Value of the Equity 14 848 € 47 087 € 57 183 € = Firm value - Debt = 76 183 - 19 000)
Change in value of Equity 21% = 57 193/47 087 - 1
Market Value of Equity 9 500 € 47 087 €
Upside/(downside) 56% 0%
Returns Calculation
Target Acquirer Combined Firm
Capital Employed 10 000 € 20 000 € 39 000 € = Capital Employed for Acquirer + Acquisition value
RoCE (after tax) 14,00% 10,50% 9,0% = 5 000 x (1 - 30%)/39 000

• Will the Board support this acquisition?

 Change in financial structure, impact on
value
Use of debt to make an acquisition

Acquirer with leverage

• Step 1 : Is the target attractively valued? Yes

• Step 2 : Is the Acquirer fairly valued?
• Step 3 : What is the impact of the acquisition on the value of the Acquirer?

The acquirer appears to be fairly valued.

 Change in financial structure, impact on
value
Use of debt to make an acquisition

Acquirer with leverage

• Step 1 : Is the target attractively valued? Yes
• Step 2 : Is the Acquirer fairly valued ?

Valuation work
Target Acquirer
Estimated Value of the firm 24 348 € 49 352 €
Estimated Value of the Equity 14 848 € 26 852 €
Change in value of Equity
Market Value of Equity 9 500 € 27 000 €
Upside 56% -1%

The acquirer appears to be fairly valued.

 Change in financial structure, impact on
value
Use of debt to make an acquisition

Acquirer with Leverage

Step 3 : What is the impact of the acquisition on the value of the acquirer?

What will change as a consequence of the acquisition?

• …
• …

• …
Change in financial structure, impact on
value
Use of debt to make an acquisition : Estimate impact on value of the Acquirer (with leverage)

What will change as a consequence of the acquisition?

Acquirer +
Target Acquirer
Target
• Unlevered Beta
Beta 2 2,06
• Financial structure Market Value of Equity 9 500 € 27 000 €
• Beta Debt 9 500 € 22 500 €
Market Value of Firm 19 000 € 49 500 €
• Quantity of EBIT and FCFF
D/E Ratio 100,00% 83,33%
• Perpetuity growth rate Tax Rate 30% 30%
• Cost of debt Unlevered Beta 1,18 1,30 1,251 Weighted average, using EBIT

• Cost of Equity Cost of debt 5,00% 3,75% 6,00% Provided

• RoCE Tax rate 30% 30% 30%

EBIT 2 000 € 3 000 € 5 000 € = Sum

FCFF 1 400 € 2 425 € 3 825 € = Sum
FCFF Growth in perpetuity 2,00% 3,00% 2,63% = Weighted Average growth

• Will the banks be keen to lend money to finance this transaction?

• Will the Board approve this transaction?
Change in financial structure, impact on
value
Use of debt to make an acquisition : Estimate impact on value of the Acquirer (with leverage)
What will change as a consequence of the acquisition?
Acquirer Combined Firm
Equity 27 000 € 27 000 € Only known value
• Unlevered Beta Debt 22 500 € 41 500 € = 9 500 + 9 500 + 22 500
Total Funding 68 500 € = Equity + Debt
• Financial structure
New D/E Ratio 154% Based on values above
• Beta New Beta 2,60 = Unlevered Beta x [1+(1 - tax rate) x D/E]
• Quantity of EBIT and FCFF CoE 12,0% 12,3% 15,3% = Rf + Beta x Market Risk Premium
• Perpetuity growth rate Cost of debt, after-tax 3,5% 2,6% 4,2% Based on values above
WACC 7,8% 7,9% 8,6%
• Cost of debt
• Cost of Equity Valuation work
• RoCE Target Acquirer Combined Firm
Estimated Value of the firm 24 348 € 49 352 € 64 472 € = FCFF/(New WACC - new perpetuity growth rate)
Estimated Value of the Equity 14 848 € 26 852 € 22 972 € = Firm value - Debt = 64 472 - 41 500)
Change in value of Equity -14% = 22 972/26 852 - 1
Returns Calculation
Target Acquirer Combined Firm
Capital Employed 10 000 € 20 000 € 39 000 € = Capital Employed for Acquirer + Acquisition value
RoCE (after tax) 14,0% 10,5% 9,0% = 5 000 x (1 - 30%)/39 000

• Will the banks be keen to lend money to finance this transaction?

• Will the Board approve this transaction?
 Change in financial structure, impact on
value
Use of debt to make an acquisition

Step 3 : Estimate impact of acquisition on value of the Acquirer?

Acquirer with leverage prior to the acquisition

What will change as a consequence of the acquisition?

• Unlevered Beta
• Financial structure
• Beta
• Quantity of EBIT and FCFF
• Perpetuity growth rate

• Will the banks be keen to lend money to finance this transaction?

• Will the Board support this acquisition?
• What will be the consequences of this situation on the competitive
position of the firm?
 Change in financial structure, impact on
value
Use of debt to make an acquisition

Step 3 : Estimate impact of acquisition on value of the Acquirer?

Acquirer with leverage prior to the acquisition

• Will the banks be keen to lend money to finance this transaction?

• Not necessarily ; could demand strong guarantees

• Will the Board support this acquisition?

• No

• What will be the consequences of this situation on the competitive

position of the firm?
• If Target is acquired by an other competitor which, as a result, improves its
competitive position, the Acquirer with leverage could experience a decline in its
value
Change on financial structure, impact on
value
How to determine an adequate financial structure?

• Adding debt lowers the WACC, hence increases the value of the firm, up to a point

• The closer to the “value-maximizing” WACC, the higher the cost of Bankruptcy Risk

• The closer to the “value-maximizing” WACC, the lower the strategic flexibility, hence
the higher the opportunity cost

• How do you design a financial structure?

Relationships
FINANCIAL STRUCTURE DECISION
• WACC Curve

• Which financial structure would you recommend to maximize the value of the firm?
FINANCIAL DECISION STRUCTURE
• Value of the firm curve

• Which financial structure would you recommend to maximize the value of the firm?
• Under all circumstances?
Financial structure and relationships
What are the main contractual relationships related to a firm’s financial structure?

• …
• …
• …

What are the 2 main features of these relationships?

Financial structure decision and
relationships

What are the main contractual relationships related to a firm’s financial structure?

• Lenders and managers

• Lenders and shareholders
• Shareholders and managers

What are the 2 main features of these relationships? Notably in times of stress?

• Misalignment of interest
• Asymmetry of information
 Financial structure decision and
relationships

• Shareholders, managers, lenders and other stakeholders have diverging interests,

aka “their interests are not aligned” (As a manager I have to behave on your behalf
and my best interests are not your best interests).

 Foundation of agency theory (Ross, Mitnick, 1973 ; Jensen & Meckling for the firm, 1976)

• For example: the managers are the agents of the shareholders, called the
principals:

• Managers are incentivized on Sales growth: will spend and invest heavily to boost revenues
growth, hurting profitability and free cash generation; whilst shareholders demand increasing
FCCF generation to improve the value of the firm
 Financial structure decision and
relationships
• Shareholders, managers, lenders and other stakeholders have diverging interests, aka “their
interests are not aligned” (my best interests are not your best interests and I have to behave on
your behalf).

• Managers are agents of the lenders as lenders give managers the control of the
money provided; managers may not behave as responsibly as the lenders expect

 These situations generate costs, called agency costs (monitoring, fixing,

unresolved conflicts …), which are exacerbated by Asymmetry of information
between stakeholders characterizes relationships between stakeholders
 Financial structure decision and
relationships
• Shareholders, managers, lenders and other stakeholders have diverging interests, aka “their
interests are not aligned” (my best interests are not your best interests and I have to behave on
your behalf).
• Asymmetry of information between stakeholders characterizes relationships between stakeholders
(each stakeholder is convinced that the others know more than he/she does)

• Example :
• Managers are agents of the lenders as lenders give managers the control of the money
provided; managers may not behave as responsibly as the lenders expect
• Managers behave to maximize their own wealth at the expense of maximizing the wealth of
the shareholders, which they are supposed to do
• Etc

 These situations generate costs, called agency costs (monitoring, fixing,

unresolved conflicts …)
 These costs can be explicit or implicit (opportunity costs)
Financial structure decision and
relationships
People’s behaviours in time of stress need to be monitored even more closely
• These increasing divergences of interests between lenders and the
management of the firm are ground for conflicts

• These conflicts become increasingly expensive to bear

• Direct costs: lenders charge higher rates, fees
• Indirect costs: opportunity cost of focusing on the financial situation instead of running the
business, management dysfunctions
• …
• One benefit from rising debt :
• it may force discipline on managers to use financial resources more responsibly as
bankruptcy risk increases.
• It is an argument put forward by Private Equity firms to explain why putting a lot of debt is
acceptable and their business model is not about financial leverage strictly speaking.
Financial structure decision and
relationships
People’s behaviours in time of stress need to be monitored even
more closely

• Which decisions should be taken for the benefit of the firm in times of
significant financial stress?

• Risk taking :

• Investments decision :

• Dividends policy :
Financial structure decision and
relationships
People’s behaviours in time of stress need to be monitored even
more closely

• Which decisions should be taken for the benefit of the firm in times of
significant financial stress?

• Risk taking: Less risk appetite

• Investments decision: keep investing

• Dividends policy: reduce/cut dividends

Financial structure decision and
relationships
People’s behaviours in time of stress need to be monitored even
more closely

• Which decisions managers, shareholders could make in times of financial

distress regarding:

• Risk taking: More

• Investments decision :
• Increase from managers’ perspective
• Reduce from shareholders’ perspective
• Dividends policy :
• reduce from managers perspectives,
• increase from shareholders’ perspective
Financial structure decision and
relationships
People’s behaviours in time of stress need to be monitored even
more closely

• Which decisions lenders would like to see in times of significant financial

stress?

• Risk taking: Less risk appetite

• Investments decision: keep investing

• Dividends policy: dividends cuts

Financial structure decision and
relationships
People’s behaviours in time of stress need to be monitored even more closely
• Which decisions managers and/or shareholders could make at the detriment of the lenders in
times of financial distress regarding:

• Risk taking: managers/shareholders might be willing to take more risk ; lenders want to reduce risk

• Investments decision: managers want more investment, shareholders will underinvest, not willing to
do a wealth transfer to the lenders ; lenders will want a greater commitment by the shareholders

• Dividends policy: managers want a cut in dividends, like the lenders, shareholders want an increase
dividends or any other measures to “send” money to the shareholders before the lenders can get
their hands on it.

 Financial stress creates significant issues between stakeholders, leading

to additional costs, called Agency costs
• One benefit from rising debt: it may force discipline on managers to use
financial resources more responsibly as bankruptcy risk increases
FINANCIAL STRUCTURE DECISION
HOW TO DECIDE?
HOW MANY THEORIES AROUND?
(… quite a few …)
 Financial structure decision
• What do you think happens to the financial structure of a firm under the
following assumptions:

• No tax (neither corporate nor personal)

• All investors (current and future) have homogeneous expectations about the firm
• Investors can borrow at the same cost as the corporate
• No brokerage costs
• Debt is riskless (for corporates and investors, cost of debt = risk-free)
• Managers always act in the interest of shareholders
• All cash flows are perpetuities (EBIT is constant, debt is perpetuity)
• Business risk is measured by variability of EBIT
Yes – if you are a pair of Smarties
Yes, if you happen to be M & M
Authors of the Modigliani & Miller’s theorem
FINANCIAL STRUCTURE DECISION
In such a (wonderful) world:

The capital structure is irrelevant.

This the Modigliani-Miller theory (Proposition I).

Under these assumptions an investor can replicate, at their personal level,

the financial structure of the firm, and if there is a difference in value, it
will be “arbitraged” away (ie. as trading has no cost Investors, will
immediately trade to bring the respective prices to the same level).
Can you win the Nobel Prize with these?
Yes, sort of.
FINANCIAL STRUCTURE DECISION
In such a wonderful world :
 the capital structure is irrelevant. It has no impact on the value of the
firm.

 In other words how you slice your pizza does not change the size of
your pizza.
FINANCIAL STRUCTURE DECISION
In such a wonderful world:

the capital structure is irrelevant.

From this it comes that the WACC remains constant and is equal to the
riskiness of the business

If no debt: WACC = Re

With debt (constant cost of debt = risk-free), CoE increases as the leverage
increases
FINANCIAL STRUCTURE DECISION
Such a wonderful world: introducing corporate tax

the capital structure becomes relevant.

 The deductibility of interest expenses creates tax-savings
 with NPV of the tax-savings called Tax-shield

 Assuming stable debt in perpetuity, the value of this tax-shield =

(Tax-rate x interest expenses)/Cost of Debt

= (Tax-rate x Debt x Cost of Debt)/Cost of Debt
= Tax-rate x Debt
FINANCIAL STRUCTURE DECISION
In such a wonderful world: introducing corporate tax
 the capital structure becomes relevant.

 Value of the firm = Value of unlevered firm + Present

Value of tax savings from debt (tax-shield)
• Note: in this chart, PV of tax-savings calculated using the cost of debt (following M&M)
FINANCIAL STRUCTURE DECISION
In such a wonderful world: introducing corporate tax,and
bankruptcy costs

the capital structure becomes relevant.

 The benefit of the tax-shield …

 Value of the firm = ?????

FINANCIAL STRUCTURE DECISION
In such a wonderful world: introducing corporate tax, cost
bankruptcy risk

the capital structure becomes relevant.

 The benefit of the tax-shield is eroded by the cost of bankruptcy risk

(Reminder : cost of bankruptcy risk = severity x probability of bankruptcy)

Hence, Value of the firm = Value of unlevered Firm + tax-shield – cost of

bankruptcy risk
FINANCIAL STRUCTURE DECISION
In such a wonderful world: introducing corporate tax, bankruptcy costs, opportunity
costs, agency costs
the capital structure becomes relevant.

• The benefit of the tax-shield is eroded by the cost of bankruptcy risk,

opportunity costs, agency costs etc
• Value of the firm = value of the unlevered firm + tax-shield – cost of
bankruptcy risk – opportunity costs – all other costs

• Value of the firm = value of the unlevered firm + Net

impact of side-effects of debt (can be positive or
negative) : ADJUSTED PRESENT VALUE
FINANCIAL STRUCTURE DECISION
In such a wonderful world: introducing corporate tax, bankruptcy costs, opportunity
costs, agency costs
the capital structure becomes relevant.

• Value of the firm =

Value of the unlevered firm
+ Net impact of side-effects of debt (can be
positive or negative)
= ADJUSTED PRESENT VALUE*

* APV is usually defined as Value of the Unlevered Firm + value of tax-shield

 FINANCIAL STRUCTURE DECISION
• In such a wonderful world: introducing corporate tax, Cost of bankruptcy risk
• Exercise : Skema APV Exercise - CFM Fall 2024
Value of unlevered firm 20,000 20,000 20,000 20,000 20,000 20,000 20,000 20,000

Debt 0 2,000 4,000 8,000 15,000 20,000 25,000 30,000

Tax-rate 25% 25% 25% 25% 25% 25% 25% 25%
Tax-shield (tax-rate x Debt)

Firm value (Value of UL + Tax-shield) 20,000 20,000 20,000 20,000 20,000 20,000 20,000 20,000

Severity of Bankruptcy 20,000 20,000 20,000 20,000 20,000 20,000 20,000 20,000
Probability of bankruptcy 0.5% 2% 3% 5% 10% 20% 35% 70%
Cost of Bankrupty Risk

Firm value (Value of UL + Tax-shield - Cost of Bankruptcy

risk)

With APV = Adjusted Present value

(Note: in chart above, tax-shield calculated using cost of debt as discount rate)
With Cost of Bankruptcy risk = Severity of bankruptcy x Probability of bankruptcy
 FINANCIAL STRUCTURE DECISION
• In such a wonderful world: introducing corporate tax, Cost of bankruptcy risk
• Exercise : Skema APV Exercise - CFM Fall 2024

With APV = Adjusted Present value

(Note: in chart above, tax-shield calculated using cost of debt as discount rate)
With Cost of Bankruptcy risk = Severity of bankruptcy x Probability of bankruptcy
 FINANCIAL STRUCTURE DECISION
• In such a wonderful world: introducing corporate tax, Cost of bankruptcy risk
• Exercise : APV Students - CFM Fall 2023
Value of unlevered firm 20,000 20,000 20,000 20,000 20,000 20,000 20,000 20,000

Debt 0 2,000 4,000 8,000 15,000 20,000 25,000 30,000

Tax-rate 25% 25% 25% 25% 25% 25% 25% 25%
Tax-shield (tax-rate x Debt) 0 500 1,000 2,000 3,750 5,000 6,250 7,500

Firm value (Value of UL + Tax-shield) 20,000 20,500 21,000 22,000 23,750 25,000 26,250 27,500

Severity of Bankruptcy 20,000 20,000 20,000 20,000 20,000 20,000 20,000 20,000
Probability of bankruptcy 0.5% 2% 3% 5% 10% 20% 35% 70%
Cost of bankruptcy risk -100 -400 -600 -1,000 -2,000 -4,000 -7,000 -14,000

Firm value (Value of UL + Tax-shield -

19,900 20,100 20,400 21,000 21,750 21,000 19,250 13,500
Cost of Bankruptcy risk)

With APV = Adjusted Present value

(Note: in chart above, tax-shield calculated using cost of debt as discount rate)
 Financial structure decision:
• No mathematically precise “optimal” level,
• More a question of finding the right balance, depending on
circumstances.
• It is the result of compromises, it is a Trade-Off.

• It is used to set a target range for D/Total Capital

FINANCIAL STRUCTURE DECISION

TOT FOR TRADE-OFF THEORY

FINANCIAL STRUCTURE DECISION

What are the 3 sources of financing

available to the management of the
firm?
FINANCIAL STRUCTURE DECISION
Management has access to 3 main sources of funds:

• Debt
• Equity
• Retained Earnings (Earnings after tax – Dividends)

• Is there one “better” than the others?

• Is there one “preferred” to the others by managers?
 FINANCIAL STRUCTURE DECISION

• POT : Clue : What is the chicken doing?

FINANCIAL STRUCTURE DECISION
And here comes the POT: Pecking Order Theory
• Managers will prefer to use, first,Retained Earnings
• Then debt
• And, lastly, Equity