Basic Elements of Capital Structure

1
Basic Elements of Capital Structure

• Debt
• Basic types of debt
• Priority
• Senior
• Subordinated
• Security
• Secured
• Unsecured

2
Basic Elements of Capital Structure

• Basic characteristics of debt
• Terms of the debt
• Principal amount
• Interest payments
• Tax treatment of debt

3
Basic Elements of Capital Structure

• Equity
• Basic types of equity
• Preferred stock
• Common stock
• Basic characteristics of equity
• Terms of preferred stock
• Liquidation value
• Dividend preference
• Terms of common stock

4
Basic Elements of Valuation

• Valuation with certainty
• First fundamental principle of valuation
• 1 today is worth more than 1 tomorrow
• Valuation with uncertainty
• Second fundamental principle of valuation
• 1 for sure is worth more than 1 subject to
  risk

5
Basic Elements of Valuation (Certainty)

• Simple Interest Interest is computed solely on
  the original balance
• Example 100 is deposited for two years into a
  bank account and earns 10/year of simple
  interest
• 100 10010 110 (Year 1)
• 110 10010 120 (Year 2)
• Compound Interest Interest is computed on the
  original balance plus any unpaid interest.
• Example 100 is deposited for two years into a
  bank account and earns 10/year of compound
  interest
• 100 10010 110 (Year 1)
• 110 11010 121 (Year 2)

6
Basic Elements of Valuation (Certainty)

• Yr Simple Interest Compound Interest
• 1 110 110
• 10 200 259
• 20 300 673
• 50 600 11,739

7
Basic Elements of Valuation (Certainty)

• General application of first principle
• Future Value
• FV PV (1r)n , where n no. of periods
• So, what is the (future) value of 100 received
  today if the interest rate is 5 and the money is
  held for one year?
• FV 100 (1 0.05)1
• 100 (1.05)
• 105

8
Basic Elements of Valuation (Certainty)

• General application of first principle
• Present Value
• PV FV / (1r)n
• So, what is the present value of 100 to be
  received one year from today, if the interest
  rate is 5?
• PV 100 / (1 0.05)1
• 100 / 1.05
• 95.24

9
Basic Elements of Valuation (Certainty)

• Exercise 1
• PV FV / (1r)n
• 1.10 / (1 0.05)1
• 1.10 / 1.05
• 1.05

10
Basic Elements of Valuation (Certainty)

• Exercise 2
• PV FV / (1r)n
• 1.00 / (1 0.10)10
• 1.00 / 1.110
• 1.00 / 2.59
• 0.39

11
Basic Elements of Valuation (Certainty)

• Exercise 3
• 100 one year from today will have a higher value
  if the discount rate is 7 rather than 8
• Why?
• Discount rate is in the denominator of the
  equation, so smaller rate results in larger value
• When waiting less profitable, need more now to
  get to future value

12
Basic Elements of Valuation (Certainty)

• Question 4
• PV FV / (1r)n
• 120 150 / (1r)1
• (1r) 150 / 120
• (1r) 1.25
• r 0.25 25

13
Basic Elements of Valuation (Certainty)

• Present values can be added together to value
  (future) cash flows
• PV FV1/(1r)1 FV2/(1r)2 FVn/(1r)n
• Example IBM issues a bond today (September 17,
  2003) that promises to pay an annual coupon of
  115 every September 16 for 5 years, and return
  1,000 on September 16, 2008. If the discount
  rate is 7.5, whats the bonds value?

14
Basic Elements of Valuation (Certainty)

• Net present value
• Basic concept
• Goal determine whether an investment in a
  project is worthwhile
• Tool invest only in projects whose net present
  values are positive
• NPV PV of returns PV of costs

15
Basic Elements of Valuation (Certainty)

• NPV example Assume that you can buy a building
  for 150,000 today, must pay 100,000 next year
  for renovations, and can sell it for 350,000 in
  two years. Whats the NPV of the project if r
  7?
• NPV - 150,000 - 100,000/(1.07)
  350,000/(1.07)2
• NPV - 150,000 - 93,458 305,703
• NPV 62,245

16
Basic Elements of Valuation (Certainty)

• Another NPV example (from page 117) Assume that
  you can borrow 10,000 today in exchange for the
  promise to pay 10,850 in one year. Whats the
  NPV of the project if r 7?
• NPV 10,000 - 10,850/(1.07)1
• NPV 10,000 - 10,140
• NPV - 140
• Note distinction between interest rate (8.5) and
  discount rate (7)

17
Basic Elements of Valuation (Risk)

• Recall second fundamental principle of valuation
• 1 for sure is worth more than 1 subject to risk
• Sources of risk
• Risk of no payment at all
• Risk of payment of another amount
• Risk of payment at another time

18
Basic Elements of Valuation (Risk)

• Volatility risk and default risk
• Volatility risk is the risk imposed by the
  uncertainty of returns
• Default risk is the risk of nonpayment
• Default risk is one source of volatility risk
• In the corporate context, risk generally means
  volatility risk

19
Basic Elements of Valuation (Risk)

• Risk imposes costs on individuals
• Due to risk aversion
• Downside losses are weighed more heavily than
  upside gains
• Because individuals have declining marginal
  utility of wealth
• And due to psychological effects

20
Basic Elements of Valuation (Risk)

• Returns with risk
• Future (certain) value is replaced with expected
  value
• Principle for calculation
• EV S pi xi, where xi is a possible outcome and
  pi is the probability of that outcome

21
Basic Elements of Valuation (Risk)

• Returns with risk
• Example expected value calculation
• Coin toss 0 if heads, 15 if tails
• EV (1/2) (0) (1/2) (15)
• 7.50

22
Basic Elements of Valuation (Risk)

• Measure of risk
• Variance
• Degree of dispersion of actual returns around the
  expected return
• Greater spread implies greater risk
• Coin toss 0 if heads, 15 if tails high(er)
  risk
• Coin toss 5 if heads, 10 if tails low(er)
  risk

23
Basic Elements of Valuation (Risk)

• Measure of risk
• Discount rate
• Variance difficult to incorporate into present
  value calculations
• Higher discount rate is used
• Reflects need for higher return to compensate for
  risk

24
Basic Elements of Valuation (Risk)

• Value of future risky returns
• Must account for
• Time value of money
• Risk
• So,
• Apply present value formula (which accounts for
  time value) to
• expected value and
• incorporate risk into discount rate
• PV EV / (1r)n