Understanding business structures is essential for evaluating risk, taxation, control, and financing options.

1. Sole Proprietorship

• One owner; owner = operator
• Unlimited liability
• No separate legal identity
• All profits belong to the owner
• Taxed once as personal income
• Limited by owner’s capital & risk appetite

Analogy:

Like a single-person food truck — you run everything, keep all profit, but also bear all the risk.

2. General Partnership

• Two or more owners share control
• No separate legal identity
• Partners share unlimited liability
• Profits shared
• Taxed once (personal income)
• Limited by partners’ combined capital and risk appetite

Analogy:

Like two people co-owning a small bakery — both share profits and losses fully.

3. Limited Partnership (LP)

• Must include at least one General Partner (GP) with full control
• Limited Partners (LPs) → limited liability, limited control
• Profits shared based on contribution (GP usually more)
• Taxed once

Analogy:

GP = driver of a car
LP = passengers providing funding but limited responsibility.

4. Corporation (LLC / Inc.)

• Separate legal identity
• Can hire employees, sign contracts
• Owners = shareholders and bondholders
• Board of Directors handles governance
• Limited liability for owners
• Taxation: Double taxation (corporate + personal dividends)
• Easiest to raise capital (equity + debt)

Corporations reduce investor risk because owners cannot lose more than they invested.

Analogy:

Corporations are like cruise ships — large, regulated, and with many passengers (owners) who are not the captain.

Public Companies

• Listed & traded on exchange
• Highly liquid trading
• Share price changes with trading activity
• Heavy disclosure requirements

Private Companies

• Not exchange-traded
• Low liquidity
• Requires negotiation for share transfers
• Fewer investors, longer holding periods
• Higher potential returns due to higher risk

Share Issuance Differences

Public:

• Can issue new shares easily after listing

Private:

• Rely on private placements → fewer investors, smaller amounts

Registration & Disclosure Requirements

Public Firms:

• Must register with regulators
• Extensive financial reporting
• Information becomes publicly available

Private Firms:

• No obligation to provide full public disclosures
• Still must disclose key non-financial info

How Companies Go Public

1. IPO (Initial Public Offering)

• Underwriter involved
• Company sells new shares to public

2. Direct Listing

• No underwriter
• No new capital raised
• Existing shares simply begin trading

3. Acquisition

• Private company acquired by public company

4. SPAC (Special Purpose Acquisition Company)

• “Blank check” company raises money → buys private company
• If no deal executed, funds returned

Analogy:

SPAC = shopping mall gift card — the shell company exists purely to buy something later.

Going Back to Private: Leveraged Buyout (LBO)

• Investors borrow heavily to acquire a public firm
• Belief the public market undervalued the company

Added Explanation:

LBOs create high leverage, but allow operational restructuring outside public scrutiny.

Startup

• Low/no revenue
• Negative cash flow
• High risk
• Limited financing options

Growth

• Revenue ↑
• Cash flow ↑
• Still may be unprofitable
• Often seek public listing

Maturity

• Revenue steady, positive
• Strong cash flow
• Low risk
• Easier to obtain financing

Decline

• Revenue ↓
• Cash flow ↓
• Business risk ↑
• Difficult to obtain capital

Analogy:

Just like people: childhood → adolescence → adulthood → old age.

Debtholders (Bondholders)

• First claim on cash flows & assets
• Fixed payments (interest + principal)
• Lower risk, lower required return
• Prefer stability

Shareholders

• Dividends discretionary
• Last in priority
• Higher risk, higher potential return
• Elect board of directors

Analogy:

Debt = taking a mortgage (lower cost but must pay)
Equity = taking on a roommate (higher cost long-term but no obligation to pay monthly)

• Liability is the biggest differentiator in business structures.
• Public companies offer liquidity but face heavy reporting rules.
• SPACs are acquisition vehicles; they don’t operate businesses.
• Corporations are preferred for raising large amounts of capital.
• Debt is cheaper for firms (tax shield) but increases financial risk.
• Equity avoids default risk but dilutes ownership.
• Lifecycle stage influences financing strategy and valuation.

A stakeholder is anyone with a vested interest in the company.

Shareholders

• Want value maximization, profit growth
• Can elect the board, influence decisions
• Non-profits do not have shareholders, but have similar oversight groups

Analogy:

Shareholders are like team owners in sports — they fund the team and expect winning results.

Creditors

Banks or lenders who want principal + interest repaid.

Two Types of Creditors:

• Private lenders (banks): access non-public info, more flexible
• Public lenders (bondholders): rely on public info & credit ratings

Analogy:

Private lenders = a friend lending money
Public lenders = a bank giving you a loan with strict rules.

Board of Directors

Elected by shareholders to represent shareholder interests.

Key duties:

• Strategic decisions
• Hire/fire CEO
• Monitor management

Types of Directors

• Inside Directors: managers, founders, major shareholders
• Independent Directors: no significant compensation/relationship

Staggered Board

Only part of board is elected each year → makes hostile takeovers more difficult.

Managers

• Execute board strategy
• Want to maximize total compensation (salary + bonuses + stock options)

Employees

• Care about compensation, benefits, stability, career growth

Customers

Expect quality products/services and post-sale support

Suppliers

Want timely payments & long-term contracts

Regulators

Protect the public and economy; collect taxes

Shareholder Theory

Prioritize shareholder value only

Stakeholder Theory

Balance interests of all stakeholders

Analogy:

Shareholder theory = “maximize profit”
Stakeholder theory = “profit + people + planet”

A principal hires an agent to act on their behalf → interests may not align.

Main Conflict:

Shareholders (owners) vs Managers (agents)

Why? → Asymmetric Information

Managers know more about operations than shareholders.

Tools to Align Interests:

• Compensation tied to shares/options

But it can fail due to:

1. Entrenchment – long-tenured managers become “untouchable”
2. Empire Building – managers pursue unnecessary growth
3. Excessive Risk Taking – to boost option value

• Controlling shareholders → concentrated ownership
• Minority shareholders → dispersed ownership

Voting Systems

• Straight voting: 1 share = 1 vote
• Dual class shares: Voting power ≠ ownership %

Added Explanation:

Dual-class structures often give founders more control (e.g., tech companies).

• Shareholders want risk-taking for higher returns
• Creditors want stability
• Conflicts increase with longer-maturity debt
• Creditors protect themselves using covenants

Analogy:

Shareholders = thrill-seekers
Creditors = safety inspectors

Shareholder Mechanisms

1. Reporting & Transparency
2. Shareholder Meetings (annual or extraordinary)
3. Proxy Voting → vote on someone’s behalf
4. Shareholder Activism
5. Shareholder Lawsuits
6. Corporate Takeovers
   • Proxy contest
   • Tender offer
   • Hostile takeover

Creditor Mechanisms

1. Bond Indentures
2. Covenants (restrict leverage, dividends)
3. Periodic Reporting
4. Creditor Committees (bankruptcy/restructuring)

Board Mechanisms

Audit Committee

• Monitors financial reporting, oversees internal & external audits

Governance Committee

• Develops governance policies

Remuneration Committee

• Sets executive compensation

Nomination Committee

• Handles director selection

Risk Committee

• Manages enterprise risk & risk appetite

Investment Committee

• Reviews major investments

Employee Mechanisms

• Labor laws
• Employment contracts

Customer & Supplier Mechanisms

• Contracts
• Social media feedback

Government Mechanisms

• Regulations
• Governance codes
• Legal systems
  • Civil Law – laws created by legislature
  • Common Law – laws from legislature + judges

Key Insights:

Common Law systems favour stronger shareholder and creditor protection.

Operational Risks

• Weak controls → fraud
• Poor decision-making
• Excessive or insufficient risk-taking

Financial Risks

• Default
• Bankruptcy

• Higher efficiency
• Better performance
• Lower default risk → lower cost of debt
• Higher valuation

Growing importance as ESG affects risk, valuation, and future cash flows.

Environmental Issues

Climate change, pollution, biodiversity, deforestation, energy efficiency, waste management, water scarcity

Social Issues

Customer satisfaction, diversity, worker safety, human rights

Governance Issues

Board structure, audit quality, corruption, shareholder rights, political influence

Incorporating ESG in Investment Analysis

Equity Investors

• Identify upside & downside risk
• Adjust valuation models, scenario testing

Fixed Income Investors

• Identify default risk
• Measure relative value, spreads, duration

ESG Investment Approaches

Responsible Investing

Broad: using ESG to avoid negative consequences

Sustainable Investing

Choosing companies using ESG to create value

Socially Responsible (SRI)

Aligns investments with ethical or religious values

Negative Screening

Exclude bad ESG actors

Positive Screening

Select strong ESG performers

ESG Integration

Blend ESG with traditional analysis

Thematic Investing

Focus on themes → clean energy, water, etc.

Active Ownership

Engage management to achieve ESG goals

Impact Investing

Intentionally invest to create measurable positive impact

Common Law systems provide the strongest shareholder & creditor protections.

Corporate governance manages conflicts between shareholders, creditors, managers, and stakeholders.

Asymmetric information creates principal-agent problems.

Board committees play specific, testable roles (audit, governance, nomination, risk).

Shareholder activism & proxy voting are important governance tools.

ESG integration is becoming standard in both equity and fixed income analysis.

Negative vs. positive screening is frequently tested.

A business model explains how a company creates value:

• Who it sells to
• What it sells
• Where it sells
• How it prices

Analogy:

A business model is like a recipe — ingredients (products), target eater (customers), kitchen location (channels), and price for the dish.

Profitability

Understand margins, breakeven, and unit economics.

Business Model Types

• Producing goods
• Providing services
• Financial services

Business Model Innovation

Technology changed:

• Where goods are sold
• How they are delivered
• Marketing channels
• Outsourcing ease

Network Effects

Product becomes more valuable as more users join
Example: social media

Variations of Business Models

Private Label:

Goods produced by one firm → sold under another’s brand

Licensing Arrangements:

Royalties paid to use brand

Value-Added Resellers:

Add installation, customization, support

E-commerce Models

• Affiliate marketing (commissions)
• Marketplace (buyers + sellers)
• Aggregators (Uber, Spotify)
• Platforms (network-based)
• Hybrid models (Tesla: cars + charging network)

Target Customers (Who?)

• Geography
• Market segments
• Customer segments
• B2B vs B2C

Product / Service Offering (What?)

• What the company sells
• What differentiates it (price, quality, innovation)
• What customer need is satisfied

Differentiation drives pricing power; low differentiation leads to commodity pricing.

Channel Strategy (Where?)

• Direct, intermediaries, digital, omnichannel
• Activities: service, display, inquiries, order processing
• Assets: warehouses, retail stores, reps, website
• Firms involved: wholesalers, retailers, agents, franchisees

Traditional Flow:

Manufacturer → Wholesaler → Retailer → End Customer

Analogy:

Channels are like roads leading products from factory to customers.

Pricing Strategy (How Much?)

Pricing Levels

• Premium
• Parity
• Discount

Assess:

• Differentiation level
• Whether price is justified

Pricing Power

• Price taker → must sell at market price
• Price setter → can set higher/lower prices

Value-Based Pricing

Price set based on customer-perceived value

Analogy:

A concert ticket costs more for a famous artist even if costs are the same.

Cost-Based Pricing

Price set based on cost + margin

Price Discrimination

Charging different customers different prices

Analogy:

Senior/student discounts → same product, different price.

Tiered Pricing

Volume-based discounts

Dynamic Pricing

Price changes based on time, demand

Analogy:

Airline tickets rising as the departure date nears.

Auction-Based Pricing

Pricing through competitive bidding

Multiple-Product Pricing

Bundling

Sell products together

Razor–Blades Model

Cheap base product; expensive refills – think printers and ink refills

Optional Product Pricing

Extra add-ons at sale or later

Rapid Growth Pricing

Penetration Pricing

Lower margins initially to gain market share

Freemium

Free basic tier, pay for premium

Hidden Revenue Models

“Free” product → revenue from ads, data
Examples: Google, social media

Subscription Pricing

Customer rents product as long as needed

Fractionalization

Asset divided into time/units (e.g., timeshares)

Licensing

Royalty payments for using intangible assets

Franchising

Rights to sell product in a territory

Describes activities within the company that add value.
Steps:

1. Identify activities
2. Estimate value added + cost
3. Identify competitive advantage

Analogy:

A value chain is like a factory assembly line — each step adds value toward the final product.

Firms face external, industry-level, and firm-specific risks.

External (Macro) Risk

Includes:

• GDP growth
• Inflation
• Interest rates
• Unemployment
• Demographics (aging, immigration, labor shortages)
• Sector demand: cyclicality
• Industry costs: fixed vs variable
• Political/legal environment
• Social trends

Analogy:

Macro risk = weather conditions a pilot cannot control.

Business Risk

Industry-Specific Risk

Earnings Cyclicality: High for discretionary/durable goods

Industry Structure

Low concentration → lower margins

Competitive Intensity

Measured through ROIC, EBIT/Revenue

Porter’s 5 Forces

1. Buyers
2. Suppliers
3. Current competitors
4. New entrants
5. Substitutes

Growth & Innovation

Depends on industry maturity

Firm-Specific Risk

Competitive Risk

Losing market share; depends on:

• Pricing power
• Barriers to entry
• Disruption level

Product-Market Risk

Product may fail to meet demand

Execution Risk

Management may underdeliver

Capital Investment Risk

Poor investment decisions

ESG Risk

Failure to meet environmental/social/governance expectations

Financial Risk

Comes from capital structure (debt levels).

Key points:

1. More debt = higher default risk
2. Firms with low business risk can take more debt

Measuring Risk: Total Leverage

\text{Total Leverage} = \text{Operating Leverage} + \text{Financial Leverage}

Operating Leverage

• Comes from fixed operating costs
• Higher fixed costs → EBIT more sensitive to sales

Financial Leverage

• Comes from interest obligations
• Higher interest → net income more sensitive to EBIT

Analogy:

Operating leverage = treadmill incline
Financial leverage = extra weight in your backpack
Both increase the difficulty (risk).

Solutions to Reduce Risk

Asset-Light Models

Ownership of assets transferred to others

Lean Startups

Operate with minimal fixed costs

Pay-in-Advance Models

Reduce need for working capital

• A business model describes how value is created and captured.
• Pricing power depends on differentiation and competitive landscape.
• Industry analysis requires understanding structure, cyclicality, and value chains.
• Firm-specific risks include competition, product fit, execution, and ESG issues.
• Financial risk rises with leverage; operating leverage amplifies business cycles.
• Asset-light and lean models reduce risk by limiting fixed-cost exposure.

1. Going-Concern Projects

Required to continue business operations.
Examples:

• Machine replacement (saves costs but doesn’t increase revenue)
• Efficiency upgrades

Important:
Finance should match asset life → long-lived asset → long-term debt.

2. Regulatory / Compliance Projects

Required by government or regulators.

• High costs
• If unaffordable → company may shut down
• If affordable → creates barrier to entry

3. Expansion Projects

Add new products/services or acquisitions.

• High uncertainty
• Large capital requirement

4. Other Projects

Entering new industries, new technology, innovation.

• High risk, experimental

Capital budgeting = evaluation of long-term investments

4 Steps

1. Idea Generation
2. Investment Analysis
3. Capital Allocation Planning
4. Monitoring & Post-Audit

1. Base decisions on cash flows, not accounting income

• Accounting income includes non-cash items (depreciation)
• CF = real inflows/outflows

Analogy:

Accounting income is like a report card; cash flows are the actual money in your bank.

2. Use Incremental Cash Flows

Which cash flows change because of the project?

3. Timing Matters (Discounting)

Cash today > cash tomorrow

4. Use After-Tax Cash Flows

Taxes affect real CF

5. Ignore Financing Costs in CFs

Interest costs included in the discount rate (WACC), not CF.

Sunk Costs

Already spent → ignored

Analogy:

Like paying for a bad movie — money is gone; don’t force yourself to stay.

Externalities

Impact a new project has on existing operations.
Includes cannibalization: Introducing a new iPhone reduces sales of older models.

Conventional vs Unconventional Cash Flows

• Conventional: only one sign change
• Unconventional: multiple sign changes → IRR problems

Mutually Exclusive Projects

Choose one option only

Project Sequencing

Some projects depend on others’ success

NPV (Net Present Value)

$$NPV=\sum \frac{C{F}_t}{(1+r{)}^t}-\text{Initial Investment}$$

• Positive NPV → accept
• Measures dollar value added to firm

IRR (Internal Rate of Return)

Discount rate that makes NPV = 0

• If IRR > required return → accept

Analogy:

IRR is the project’s “interest rate.”

NPV vs IRR

Independent Projects

NPV & IRR agree

Mutually Exclusive Projects

NPV & IRR may conflict → choose higher NPV

Why conflict?

• Differences in project size
• Differences in timing of cash flows

Unconventional Cash Flows

• IRR may have multiple IRRs
• NPV always reliable

Pros & Cons

NPV Pros

• Directly measures value creation
• Assumes reinvestment at required rate of return (realistic)

NPV Cons

• Does not reflect project scale

IRR Pros

• Easy to compare to required return
• Expressed as a % (intuitive)

IRR Cons

• Assumes reinvestment at IRR
• Can conflict with NPV
• Fails with unconventional CF

Capital Allocation Pitfalls

• Inertia: budget tied to previous year
• Source-of-capital bias: internal funds seen as free
• Not considering alternatives
• Pet Projects: leadership bias
• Using accounting metrics instead of CF
• Forecasting errors

ROIC vs Cost of Capital

$$ROIC=\frac{\text{After-Tax Operating Profit}}{\text{Book Value of Invested Capital}}$$

• If ROIC > cost of capital → value increases
• If ROIC < cost of capital → value decreases

NPV & Stock Price

Positive NPV should increase stock price proportionally,
but markets respond to expectations, not just fundamentals.

• Nominal CF include inflation
• Real CF exclude inflation
• Use nominal rate with nominal CF
• Higher inflation:
  • Reduces margins
  • Lowers tax shield from depreciation

Real options give managers flexibility to adjust investment decisions.
4 Types of Real Options:

1. Timing Option

Delay investment until better info available

2. Sizing Option

Expand or abandon depending on performance

3. Flexibility Option

Adjust pricing or operations

4. Fundamental Option

Project itself behaves like an option (e.g., R&D)

How to Value Real Options

Three approaches:

1. DCF (basic)
   • If NPV negative:$$NP{V}_{project}=NP{V}_{DCF}-\text{Cost of Options}+\text{Value of Options}$$
2. Decision Trees
3. Option Pricing Models (e.g., Black-Scholes)

• Cash flow—not accounting income—is the foundation of capital budgeting.
• Ignore sunk costs; include cannibalization and externalities.
• NPV is superior to IRR for mutually exclusive or unconventional CF projects.
• ROIC vs WACC determines value creation.
• Inflation affects both cash flows and discount rates.
• Real options add significant value by giving managers flexibility.

Working Capital = Current Assets – Current Liabilities

Goal:

• Ensure the company can meet daily operational needs
• But avoid holding excess idle assets

Analogy:

Working capital is like the gas in your car — too little and you stall; too much and you’re carrying unnecessary weight.

Components of Working Capital

Current Assets

• Accounts receivable
• Inventory
• Short-term investments (marketable securities)

Current Liabilities

• Accounts payable
• Short-term debt

Internal Methods to Improve Working Capital

• Generate more operating cash flow
• Shorten the cash conversion cycle
• Convert liquid assets into cash

Cash conversion cycle = amount of time between paying suppliers and collecting cash from customers.

1. After-Tax Operating CF

$$\text{After-Tax CF}=NI+Depreciation-Dividends$$

Analogy:

Think of this as cash generated internally before seeking external financing.

2. Accounts Payable

What suppliers are owed.
Example credit term: 2/10 net 40 → 2% discount if paid in 10 days; otherwise due in 40 days.

3. Accounts Receivable

Money customers owe.
Higher receivables → weaker working capital unless collections improve.

4. Inventory

Must balance stock availability vs. holding cost.

5. Marketable Securities

Short-term investments easily converted to cash.

Uncommitted Lines of Credit

• Bank is not obligated to lend
• Least reliable

Committed Lines of Credit

Reliable; formal agreement

Revolving Credit Facility

Multi-year committed line; best short-term funding tool

Secured Loans

Collateral required

Factoring

Sell receivables at a discount for immediate cash

Analogy:

Factoring is like selling a concert ticket for less than face value because you need cash today.

Web-Based / Non-Bank Lenders

Quick approval but usually higher cost

Commercial Paper

• Short-term debt issued by large, well-rated companies
• Low cost

Long-Term Options

• Public or private debt
• Hybrid securities (preferred, convertibles)
• Common equity
• Leasing

Three factors:

1. Inventory needs
2. Receivables (as a % of sales)
3. Payables (as a % of sales)

1. Conservative Approach

• Holds more current assets
• Finances with long-term debt or equity

Pros

• Stable, permanent financing
• Reduced rollover risk
• Higher flexibility in stress periods
• Certainty of WC availability

Cons

• High financing costs
• Long lead time
• Less ability to “borrow as needed”
• Long-term debt covenants

Analogy:

Like keeping a large emergency fund—very safe but costly.

2. Aggressive Approach

• Holds fewer current assets
• Uses short-term debt and payables

Pros

• Lower financing costs
• Borrow only when needed
• Can refinance when rates fall

Cons

• Higher rollover risk
• Short-term funding volatility
• Must maintain tight credit control

Analogy:

Running your car with near-empty tank — cheaper, but risk of running out.

3. Moderate Approach

• Matches duration:
  • Permanent WC → long-term debt
  • Variable WC → short-term debt

Pros

• Lower cost than conservative
• Flexibility for seasonal spikes
• Diversified funding sources

Cons

• Still has short-term rollover risk
• May rely on trade credit

Analogy:

Like keeping moderate gas in the tank — safe but still efficient

Definition

• Liquidity: ability to meet short-term obligations
• Liquidity Management: ability to generate cash at low cost

Primary Sources of Liquidity

• Free cash flows
• Cash balances
• Short-term funds (trade credit, credit lines, short-term investments)

Secondary Sources of Liquidity

• Renegotiating debt terms
• Liquidating assets
• Filing for bankruptcy protection

Added Explanation:

These are used only when the firm is under financial stress.

Factors Affecting Liquidity

Pulls on Liquidity (accelerate outflows)

• Paying suppliers early
• Suppliers reducing credit limits
• Restrictions on credit lines
• Low initial liquidity

Drags on Liquidity (slow inflows)

• Slow receivables collection
• Obsolete inventory
• Tight credit environment

Analogy:

Pulls = water leaking from a bucket
Drags = water flowing slowly into it

Measuring Liquidity

Current Ratio

$$\text{Current Ratio}=\frac{CA}{CL}$$

Quick Ratio (Acid Test)

$$\text{Quick Ratio}=\frac{\text{Cash + Marketable Securities + Receivables}}{CL}$$

Cash Ratio

$$\text{Cash Ratio}=\frac{\text{Cash + Marketable Securities}}{CL}$$

Short-Term Funding Objectives

• Handle peak cash needs
• Maintain diversified credit sources
• Borrow at cost-effective rates
• Consider all explicit & implicit costs

Factors in Short-Term Borrowing

• Firm size & creditworthiness
• Legal/regulatory environment
• Asset quality (collateral availability)
• Flexibility across maturities

Borrowing Strategies

Passive Strategy

• Minimal planning
• Rely on one source
• Roll over continuously

Active Strategy

• More planning, diversified structure
• Matching strategy: loan payments match cash receipts
• Avoids rollover trap

Analogy:

Matching strategy = scheduling your loan payments right after payday so you never fall behind.

• Working capital must balance liquidity with efficiency.
• Conservative vs aggressive WC approaches affect risk/return tradeoffs.
• Credit terms (2/10 net 40) heavily influence payable strategy.
• Liquidity analysis focuses on ratios + cash flow behavior.
• Factoring increases liquidity but at a cost.
• Short-term funding strategies must avoid rollover risk.

WACC = the firm’s overall required return, used as the discount rate for average-risk projects.
$$WACC=W_d{r}_d(1-t)+W_p{r}_p+W_e{r}_e$$

Where:

• $W_d,W_p,W_e$​ = weights of debt, preferred stock, equity
• $r_d,r_p,r_e$ = required returns (cost of debt, preferred, equity)
• (1 – t) = tax shield on interest

Key Rules for WACC

✔ Use market values, not book values
✔ WACC represents the return for the average project
✔ For riskier projects, increase the discount rate
✔ For safer projects, decrease the discount rate

Common Mistakes

❌ Using coupon rate instead of YTM
❌ Using book values instead of market values
❌ Using the same WACC for all projects regardless of risk

Analogy

Think of WACC as a smoothie made of debt, equity, and preferred stock. The flavor (required return) depends on how much of each ingredient is in the mix.

The return lenders demand.

Two Methods to Estimate Cost of Debt

1. Yield-to-Maturity (YTM) Approach

Use the bond’s market yield, not the coupon rate.

Common mistake:

Using the coupon rate, which represents historical cost, not current required return.

2. Debt-Rating Approach

• Used when yield is not observable
• Look at similarly rated corporate bonds in the market
• Take average yield for the firm’s rating category

$$r_p=\frac{D_p}{P_0}$$

Dividend / current price

Tax note:

Taxes do not affect preferred stock cost because preferred dividends are not tax-deductible.

1. CAPM (Capital Asset Pricing Model)

$$r_e=r_f+\beta (r_m-r_f)$$

Where:

• $r_f$r = risk-free rate
• $r_m-r_f$ = market risk premium
• $\beta$ = measure of systematic risk

2. Bond-Yield + Risk Premium Method

$$r_e=\text{Bond Yield}+\text{Risk Premium}$$

Useful when CAPM inputs are noisy.

Beta measures a firm’s systematic (market) risk.
Higher beta → higher market sensitivity → higher required return.

For Public Companies

Run regression:$$R_i=\alpha +\beta R_m+ϵ$$

• Beta = slope of regression line
• If β = 3 → stock moves 3% for every 1% in market

Adjusted Beta

$${\beta }_{adj}=\frac{2}{3}{\beta }_{raw}+\frac{1}{3}(1)$$

Pulls raw beta toward 1 (market tendency).

Factors affecting beta estimation

• Index selected
• Return interval (daily / monthly / annual)
• Time horizon

Private / Thinly-Traded Companies

Use comparable companies.

Step 1: Un-lever the peer company’s beta

Peer beta (levered) is affected by peer debt.
To strip out peer leverage:$${\beta }_u=\frac{{\beta }_L}{1+(1-t)\frac{D}{E}}$$

Step 2: Re-lever beta for the target firm

Apply target firm’s capital structure:$${\beta }_L={\beta }_u(1+(1-t)\frac{D}{E})$$

Analogy:

Unlevering and relevering beta is like removing someone’s backpack weight and then adding your own to measure their true running speed.

Flotation Costs

Fees paid to investment banks when raising capital.

✔ Do NOT include flotation costs in WACC
❌ Some candidates adjust cost of equity or cost of debt — WRONG
✔ Include flotation costs only in the initial cash outflow of a project

• WACC is the discount rate for average-risk projects.
• Use market values for capital structure weights.
• Debt has a tax shield → use $r_d(1-t)$rd​(1−t).
• Cost of equity typically highest, because equity holders take the most risk.
• Beta measures systematic risk, not total risk.
• Unlever and relever beta when evaluating private firms.
• Never include flotation costs in WACC — only in initial project cash flows.

1. Business Model & Asset Characteristics

Types of Assets (affects ability to borrow)

• Tangible assets: safer collateral → support more debt
• Intangible assets: less collateral value
• Fungible assets: can be easily substituted (one dollar = another)
• Non-fungible assets: unique (art) → hard to collateralize
• Liquid assets: easily sold → increase borrowing capacity

Asset Ownership

• Asset-heavy firms:
  • Many assets on the balance sheet
  • Easily used as collateral → can support more debt
• Asset-light firms:
  • Outsource or rent assets
  • Lower operating leverage → lower business risk → can support more financial leverage

Analogy:

Assets are your home’s value when applying for a mortgage — more assets → more borrowing power.

2. Existing Leverage & Financial Strength

Companies consider:

• Liquidity ratios
• Profitability ratios
• Leverage ratios
• Interest coverage

Explanation:

A company already heavily leveraged will hesitate to add more debt to avoid distress.

3. Corporate Tax Rate

• Interest is tax deductible
• Higher tax rate → larger tax shield → more incentive to use debt

4. Policies and Guidelines

Companies set internal rules, such as:

• Debt/equity < 1
• Debt ≤ 25% of capital
• Debt/EBITDA < 2×
• Based on covenants, rating agency thresholds, or index requirements

5. Company Life Stage

• Startup: unstable cash flows → difficult to issue debt
• Growth: improving access
• Mature: predictable cash flows → highest ability to borrow

1. Market Conditions

• Cost of debt = risk-free rate + credit spread
• Recessions → wider credit spreads → more expensive debt

2. Regulatory Constraints

Some industries have:

• Solvency requirements
• Pricing rules

3. Industry / Peer Norms

Firms resemble peers due to:

• Similar business risk
• Similar asset structure

• Startup → Low leverage (unstable CF)
• Growth → Moderate leverage
• Mature → Higher leverage

Exceptions

• Capital intensive (airlines):
  High leverage in all stages; assets are valuable collateral.
• Cyclical industries:
  Limited debt due to volatile CF.
• Capital-light industries (software):
  Low leverage, high cash.

MM helps explain how capital structure affects firm value.

MM Proposition I — NO TAXES

Value of a firm is unaffected by capital structure.
$$V_L=V_U$$

Assumptions:

1. Homogeneous expectations
2. Perfect capital markets
3. Borrowing/lending at risk-free rate
4. No agency costs
5. Financing decisions do not affect investments

Analogy:

Rearranging pieces of a pizza doesn’t change the size of the pizza.

MM Proposition II — NO TAXES

Capital structure changes who gets paid, but overall WACC remains constant.$$WACC=\frac{D}{V}{r}_d+\frac{E}{V}{r}_e$$

As debt increases:

• $r_e$ increases (equity becomes riskier)
• More weight on cheaper debt
• Net effect: WACC stays the same

MM Proposition I — WITH TAXES

Debt adds value due to the tax shield:$$V_L=V_U+tD$$

Where t = tax rate and D = debt level.

MM Proposition II — WITH TAXES

WACC decreases as leverage increases:$$WACC=\frac{D}{V}(1-t)r_d+\frac{E}{V}{r}_e$$

Debt becomes even cheaper after tax adjustment.

Why don’t firms take on unlimited debt?
Because higher debt → higher expected cost of:

• Bankruptcy
• Distress events

This offsets the tax benefits of debt.

Analogy:

Borrowing too much is like loading a truck beyond capacity — eventually it breaks down.

The structure where:

• Firm value is maximized
• WACC is minimized

Static Trade-Off Theory

$$V_L=V_U+tD-PV(\text{financial distress costs})$$

Goal: Choose D/E that maximizes $V_L$

Calculating Capital Structure

Use market values of debt and equity.

Why sometimes book values are used:

• Market values volatile
• Managers focus on capital invested rather than market perception
• Third-parties may rely on book values
• Financing decisions depend on conditions (opportunistic)

Managers prefer financing that sends the least negative signal:

1. Internal funds first
2. Debt second
3. Equity last

Explanation:

Issuing equity may signal shares are overvalued → negative reaction.

Managers (Agents) vs Owners (Principals)

Managers want high compensation; owners want firm value maximized.

Agency Costs: arise from these conflicts.

Free Cash Flow Hypothesis (FCF)

More debt → forces managers to use cash efficiently (must make payments).

Creditors vs Shareholders

• Creditors want: low risk, low debt
• Shareholders want: higher leverage for higher returns

Board of Directors vs Managers

• Equity compensation aligns incentives
• But stock options can incentivize:
  • Share buybacks
  • Reduced dividends
    (to boost option value)

• Optimal capital structure minimizes WACC and maximizes firm value.
• Tangible & liquid assets increase borrowing capacity.
• High tax rates → stronger incentives to use debt.
• According to MM with taxes, more debt increases firm value (up to a point).
• Financial distress costs stop firms from using too much debt.
• Market values should be used for capital structure weights.
• Pecking Order Theory explains why firms prefer internal → debt → equity financing.
• Agency issues influence capital structure decisions.

Leverage = the amount of fixed costs a company uses
→ Either operating fixed costs or financial fixed costs (interest)

Why it matters:

• Higher leverage → earnings more volatile
• Small change in sales → large change in profit
• Higher volatility → higher risk → higher cost of capital

Analogy:

Leverage is like skiing downhill with stiffer boots — small movements create big effects. Great if controlled, dangerous if not.

Financial Risk

Risk from using debt (interest obligations).

Sales Risk

Variability in profitability caused by uncertain prices or sales volume.

Operating Risk

Risk arising from fixed operating costs (rent, salaried labor, depreciation).

Business Risk

$$\text{Business Risk}=\text{Sales Risk}+\text{Operating Risk}$$

Analogy:

Business risk = the roughness of the road, while financial risk = the amount of weight in the car.

1. Degree of Operating Leverage (DOL)

Measures operating risk

DOL tells you:

• How sensitive EBIT is to changes in sales
• How many fixed operating costs the firm has

If fixed costs removed → DOL = 1 (no operating leverage)

CFA Formula Version:

$$DOL=\frac{\mathrm{\%}\mathrm{\Delta }EBIT}{\mathrm{\%}\mathrm{\Delta }Sales}$$

Analogy:

Operating leverage is like the gear in a car — higher gear amplifies speed changes.

2. Degree of Financial Leverage (DFL)

Measures financial risk

DFL tells you:

• How sensitive Net Income is to changes in EBIT
• How much debt the firm carries

$$DFL=\frac{\mathrm{\%}\mathrm{\Delta }NI}{\mathrm{\%}\mathrm{\Delta }EBIT}$$

Analogy:

Financial leverage is like borrowing money to invest — gains are amplified but so are losses.

3. Degree of Total Leverage (DTL)

The combined effect of operating + financial leverage
$$DTL=DOL\times DFL$$

Interpretation:

How sensitive Net Income is to changes in Sales.

Analogy:

DTL is the overall amplification — like turning up both the volume (operating leverage) and the bass boost (financial leverage) on a speaker.

Higher financial leverage → higher ROE

Why?

• After interest is paid, remaining earnings belong to shareholders
• More debt → fewer shareholders (lower equity base)
• Income spread over fewer owners → higher ROE

BUT:

Higher financial leverage also increases probability of bankruptcy.

Break-even quantity = number of units that must be sold so that net income = 0

Contribution Margin

$$\text{Contribution Margin}=\text{Price per Unit}-\text{Variable Cost per Unit}$$

This represents how much each unit contributes to covering fixed costs.

Break-Even Formula

$$Q_{BE}=\frac{\text{Fixed Costs}}{\text{Contribution Margin}}$$

Analogy:

Break-even is like filling a bucket with a hole at the bottom (fixed costs). Each cup of water (unit sold) fills it a little until it finally reaches the top.

• Leverage increases earnings volatility and therefore risk.
• Operating leverage comes from fixed operating costs, financial leverage from debt.
• Higher leverage → higher sensitivity of profits to changes in sales.
• DOL, DFL, and DTL quantify how risks flow through the income statement.
• Financial leverage can increase ROE, but also financial distress.
• Break-even analysis helps managers evaluate cost structures and risk exposure.