THE OPTIMAL CAPITAL STRUCTURE (cont’d).
THE USE OF LEVERAGE - LBOs
Lesson 7
Corporate Finance
2nd
Castellanza,
November, 2011
The choice of the optimal capital structure
Maximization of ROE
Maximization of the enterprise value
Other key-drivers
(balance, flexibility, opportunities, …)
Corporate Finance
Maximization of shareholders’ return
ROE = [ROI + (D/E) (ROI – i)]
where: ROE = net profit / equity
ROI = Ebit / invested capital (debt + equity)
D/E = financial leverage
i = cost of debt (interest rate)
Corporate Finance
Relationship between ROE and ROI
Decrease
ROI
Decrease
ROE
Increase cost
of debt
Decrease
self - financing
Increase debt
ROE = [ROI + (D/E) (ROI – i)]
Corporate Finance
Modigliani-Miller theory
Hp: in an environment where there are no taxes, bankruptcy risk or
agency costs (no separation between stockholders and managers),
capital structure is irrelevant.
Ts: the value of a firm (V) is indipendent of its debt ratio (D/E). The
cost of capital of the firm will not change with leverage.
V
Va
D/E
Corporate Finance
Modigliani-Miller theory (cont’d)
The effect of taxes
V
Vl = Vu+ Vats
Vl
Vu
Vu = value of unlevered firm
Vl = value od levered firm
Vats = actual value of tax shields
D/E
Corporate Finance
Trade-off theory
The effect of bankruptcy costs
Value of levered firm without bankruptcy costs
Vabc
Value of levered firm
VAts
Value of unlevered firm
Vl = Vu + Vats - Vabc
VAcf actual value of bankruptcy costs
Corporate Finance
Pecking order theory
Financing sources
internal
external
1. self-financing
2. debt
3. increase of equity
Corporate Finance
Financing mix decision
1. Macroeconomic context (capital markets)
2. Industry (maturity, capex, risk, etc.)
3. Firm’s characteristics (market position, financialeconomic situation, ..)
4. Financial needs’ charact.
Corporate Finance
Leveraged Buyout deals
Definition:
A leveraged buyout, or LBO, is the purchase of a company
using a large amount of debt -- much of the borrowing
secured by the assets of the company itself. Sometimes
the target company’s assets are sold to repay the loan
that financed the takover
Deal:
Step 1)
Step 2)
Step 3)
Step 4)
NEWCO creation
NEWCO funding
Sellers’ payment
Merger
Corporate Finance
LBO - Steps
Step 1:
creation
NEWCO
Step 4:
merger
Step 2: funding
INVESTORS
Step 3:
payment
TARGET’S
SHAREHOLDERS
TARGET
Corporate Finance