A Conceptual Look Relevant Rates of return Ko E an overall capitalization rate for the firm Net operating income Total market value of the firm Assumptions: VEB+S=total market value of the firm o=1+E=net operating income interest paid plus earnings available to common shareholders 17-6
17-6 O V A Conceptual Look -- Relevant Rates of Return = = ko = an overall capitalization rate for the firm Net operating income Total market value of the firm ko Assumptions: • V = B + S = total market value of the firm • O = I + E = net operating income = interest paid plus earnings available to common shareholders
Capitalization Rate Capitalization rate, Ko, -- the discount rate used to determine the present value of a stream of expected cash flows B B+ s e B+S What happens to Ki, Ke, and k when leverage, B/s, increases? 17-7
17-7 Capitalization Rate Capitalization rate, ko , -- the discount rate used to determine the present value of a stream of expected cash flows. ko ki ke B B + S S B + S = + What happens to ki , ke , and ko when leverage, B/S, increases?
Net Operating Income Approach Net Operating Income Approach -a theory of capital structure in which the weighted average cost of capital and the total value of the firm remain constant as financial leverage is changed Assume: Net operating income equals $1, 350 Market value of debt is $1, 800 at 10% interest Overall capitalization rate is 15% 17-8
17-8 Net Operating Income Approach Assume: Net operating income equals $1,350 Market value of debt is $1,800 at 10% interest Overall capitalization rate is 15% Net Operating Income Approach -- A theory of capital structure in which the weighted average cost of capital and the total value of the firm remain constant as financial leverage is changed
Required Rate of Return on Equity Calculating the required rate of return on equity Total firm value=o/k =$1,350 /.15 =$9,000 Market value =V-B $93000-$1,800 of equity =$7,200 Interest payments =$1,800*10% Required return =E/S on equity =(51,350-$180)/$7200 =16.25% 17-9 *B/S=$1,800/$7,200=25
17-9 Required Rate of Return on Equity Total firm value= O / ko = $1,350 / .15 = $9,000 Market value = V - B = $9,000 - $1,800 of equity = $7,200 Required return = E / S on equity* = ($1,350 - $180) / $7,200 = 16.25% Calculating the required rate of return on equity * B / S = $1,800 / $7,200 = .25 Interest payments = $1,800 * 10%
Required Rate of Return on Equity What is the rate of return on equity if B=$3,000? Total firm value=o/k =$1,350 /.15 =$9,000 Market value =V-B $93000-$3,000 of equity =$6,000 Interest payments =$3,000*10% Required return =E/S on equity =(51,350-$300)/$6,000 =17.50% 17-10 *B/S=$3,000/$6,000=50
17-10 Total firm value= O / ko = $1,350 / .15 = $9,000 Market value = V - B = $9,000 - $3,000 of equity = $6,000 Required return = E / S on equity* = ($1,350 - $300) / $6,000 = 17.50% Required Rate of Return on Equity What is the rate of return on equity if B=$3,000? * B / S = $3,000 / $6,000 = .50 Interest payments = $3,000 * 10%