Lesson 6
THE OPTIMAL CAPITAL STRUCTURE (cont’d).
THE USE OF LEVERAGE - LBOs
Corporate Finance – Prof. Bollazzi
Cattaneo University - LIUC
The choice of the optimal capital structure
Maximization of ROE
Maximization of the enterprise value
Other key-drivers (balance, flexibility,
opportunities, …)
Corporate Finance – Prof. Bollazzi
Cattaneo University - LIUC
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 – Prof. Bollazzi
Cattaneo University - LIUC
Relationship between ROE and ROI
Decrease ROI
Increase cost of debt
Decrease
self - financing
Decrease ROE
Increase debt
ROE = [ROI + (D/E) (ROI – i)]
Corporate Finance – Prof. Bollazzi
Cattaneo University - LIUC
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 – Prof. Bollazzi
Cattaneo University - LIUC
Modigliani-Miller theory (cont’d)
The effect of taxes
V
Vl = Vu+ Vats
Vl
Vu = value of unlevered firm
Vl = value od levered firm
Vats = actual value of tax shields
Vu
D/E
Corporate Finance – Prof. Bollazzi
Cattaneo University - LIUC
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 – Prof. Bollazzi
Cattaneo University - LIUC
Pecking order theory
internal
Financing sources
external
1. self-financing
2. debt
3. increase of equity
Corporate Finance – Prof. Bollazzi
Cattaneo University - LIUC
Financing mix decision
1. Macroeconomic context (capital markets)
2. Industry (maturity, capex, risk, etc.)
3. Firm’s characteristics (market position, financial-economic
situation, ..)
4. Financial needs’ charact.
Corporate Finance – Prof. Bollazzi
Cattaneo University - LIUC
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 – Prof. Bollazzi
Cattaneo University - LIUC
LBO - Steps
STEP 1
(creation)
NEWCO
STEP 4
(merger)
TARGET
Corporate Finance – Prof. Bollazzi
STEP 2
(funding)
INVESTORS
STEP 3
(payment)
TARGET’s
SHAREHOLDERS
Cattaneo University - LIUC