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    Homemade Leverage - Example

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    Muneeb Gul
    Ri = Rf + Bi(Rm - Rf) = 7% + 2(14.5% - 7%) = 7% + 2 x 7.5% = 7% + 15% = 22% Therefore, the cost of equity is 22%.

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    Homemade Leverage - Example

    Uploaded by

    Muneeb Gul
    37 views7 pages
    Ri = Rf + Bi(Rm - Rf) = 7% + 2(14.5% - 7%) = 7% + 2 x 7.5% = 7% + 15% = 22% Therefore, the cost of equity is 22%.

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    Cost of Capital 2

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    Ri = Rf + Bi(Rm - Rf) = 7% + 2(14.5% - 7%) = 7% + 2 x 7.5% = 7% + 15% = 22% Therefore, the cost of equity is 22%.

    Copyright:

    © All Rights Reserved
    Download as PPTX, PDF, TXT or read online from Scribd
    Download as pptx, pdf, or txt
    37 views7 pages

    Homemade Leverage - Example

    Uploaded by

    Muneeb Gul
    Ri = Rf + Bi(Rm - Rf) = 7% + 2(14.5% - 7%) = 7% + 2 x 7.5% = 7% + 15% = 22% Therefore, the cost of equity is 22%.

    Copyright:

    © All Rights Reserved
    Download as PPTX, PDF, TXT or read online from Scribd
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    Homemade Leverage - Example

    Co. A and Co. B are identical firms in all respects except for their
    capital structure. B is all equity financed with 1,500,000 in
    stock. A uses both stock and perpetual debt: its stock worth
    900,000 and the interest rate on the debt is 10 percent. Both
    firms expect EBIT to be $120,000,000. Ignore taxes.

    a)Wamiq owns 45 million worth of A shares. What will be the


    earning from A if all income is distributed?
    b)Show how Wamiq could generate exactly the same earning by
    investing in B and using homemade leverage?
    c)What is the cost of equity for A? What is it for B?
    d)What is the WACC for A? For B? What principle have you
    illustrated?
    MM Propositions I & II (With Taxes)
    • Proposition I (with Corporate Taxes)
    – Firm value increases with leverage
    VL = VU + TC B
    • Proposition II (with Corporate Taxes)
    – Some of the increase in equity risk and return is
    offset by the interest tax benefit
    RS = R0 + (B/S)×(1-TC)×(R0 - RB)
    RB is the interest rate (cost of debt)
    RS is the return on equity (cost of equity)
    R0 is the return on unlevered equity (cost of capital)
    B is the value of debt
    S is the value of levered equity
    Summary: No Taxes
    • In a world of no taxes, the value of the firm is unaffected by
    capital structure.
    • This is M&M Proposition I:
    VL = VU
    • Proposition I holds because shareholders can achieve any
    pattern of payouts they desire with homemade leverage.
    • In a world of no taxes, M&M Proposition II states that leverage
    increases the risk and return to stockholders.

    B
    RS  R0   ( R0  RB )
    SL
    Summary: Taxes
    • In a world of taxes, but no bankruptcy costs, the value of the
    firm increases with leverage.
    • This is M&M Proposition I:
    VL = VU + TC B
    • Proposition I holds because shareholders can achieve any
    pattern of payouts they desire with homemade leverage.
    • In a world of taxes, M&M Proposition II states that leverage
    increases the risk and return
    B to stockholders.
    RS  R0   (1  TC )  ( R0  RB )
    SL
    Interpreting WACC
    • Tax Vs no tax
    • Cost of debt financing increases the risk for
    equity holders so their expectation of return
    becomes higher…..meaning that incremental
    debt financing can increase the WACC
    • It provides a bench mark below which
    investments should not be made
    CAPM
    Ri = Rf + Bi (Rm – Rf)
    Sensitivity of a stock to market = Beta
    Premium required over risk free return
    Betas reflect the sensitivity of each firm’s profits to the general health of the
    economy. For example, Technology stocks have high betas (well over 1) because
    demand for their products usually varies with the business cycle: Companies and
    consumers tend to invest in technology when times are good, but they cut back
    on these expenditures when the economy slows. In contrast, the demand for
    personal and household products has very little relation to the state of the
    economy. Firms producing these goods, such as Procter & Gamble, tend to have
    very low betas (near 0.5).
    Example
    Share price = 90, Government bond rate = 7%,
    Share price fluctuates twice as average market, 100 index return = 14.5%
    Tax rate = 20%, CPI (Inflation) = 13%, Population growth rate = 2.3%,
    Corruption rate = 99.9%

    Ri = What is the cost of Equity?


    Rf = 7%
    Rm= 14.5%
    B=2

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