Capital Structure, Project Cash Flows, WACC and IRR
Capital Structure (Ch 16)
Capital structure = mix of debt and equity.
Unlevered = no debt.
Levered = some debt.
Financial leverage = fixed interest that magnifies EPS.
Debt is cheaper because interest is tax deductible.
Companies avoid all debt because too much raises bankruptcy risk.
When debt helps shareholders
Return on assets > cost of debt.
EPS after borrowing > EPS before.
When debt hurts shareholders
Return on assets < cost of debt.
EPS decreases.
Break-Even EBIT (BEEBIT)
BEEBIT graph: break-even EBIT is where EPS (levered) = EPS (unlevered).
Vertical intercept = interest expense.
Unlevered line starts at 0 because there is no interest.
Line with steeper slope = more debt.
If EBIT > BEEBIT → debt helps.
If EBIT < BEEBIT → debt hurts.
Project Cash Flows (Ch 10)
Incremental cash flows = created ONLY by accepting the project.
Include: opportunity costs, erosion, synergy, changes in net working capital (NWC).
Exclude: sunk costs.
NWC Rules
- At start: NWC ↑ → cash outflow
- At end: NWC ↓ → cash inflow
- NWC and cash always move in opposite directions.
Four parts of project cash flows
- Operating cash flow
- Change in NWC
- Capital spending
- Salvage flow
Depreciation
Straight-line depreciation = (Cost + installation − salvage) / life
Accumulated depreciation = annual depreciation × years
Book value = cost + installation − accumulated depreciation
Salvage Cash Flow
Salvage cash flow = Sale price − tax × (Sale price − book value)
If sold below book value → tax credit → cash flow > sale price.
If sold above book value → tax owed → cash flow < sale price.
Cost of Capital (Ch 11)
Cost of capital = minimum required return; the hurdle rate.
Lower WACC → higher firm value. Higher WACC → lower firm value.
WACC
WACC = (We × Re) + (Wd × Rd × (1 − T)) + (Wp × Rp)
Equity weight = market value of equity / market value of total capital.
MV equity = shares × price.
MV debt = bonds × bond price.
Unlevered WACC weights
Debt weight = 0
Equity weight = 1
Net Present Value (NPV) (Ch 9)
NPV = −initial cost + Σ [CFt / (1 + r)^t]
Decision rule: NPV > 0 → accept; NPV < 0 → reject
Excel: =NPV(rate, CF1:CFn) + initial cost
NPV Profile
- Vertical axis = NPV
- Horizontal axis = discount rate
- Vertical intercept = NPV at discount rate = 0%
- IRR = discount rate where NPV = 0
Cost of Equity
Dividend Growth Model
Next dividend = last dividend × (1 + g).
Re = next dividend / price + g.
CAPM
Re = risk-free rate + beta × (market return − risk-free rate).
Cost of Preferred
Cost of preferred = dividend / price.
Cost of Debt
Use yield to maturity (YTM).
Excel: =RATE(years, coupon, −price, par)
After-tax Rd = YTM × (1 − tax rate)
Internal Rate of Return (IRR)
IRR = discount rate that makes NPV = 0.
Decision: IRR > WACC → accept; IRR < WACC → reject.
Excel: =IRR(all cash flows)
IRR Quick Rules
- NPV positive → IRR higher than that rate.
- NPV negative → IRR lower than that rate.
- NPV zero → IRR equals that rate.
Single Inflow IRR
IRR = (FV / Initial cost)^(1 / years) − 1
Excel: =(FV / InitialCost)^(1 / Years) − 1
Multiple IRR
Happens when cash flow signs change more than once.
Use NPV instead of IRR when multiple IRRs occur.
Notes: All original content has been preserved and corrected for grammar and capitalization. Headings use h2–h3 to structure the material and important terms are emphasized for clarity.