chapter15_1_a

chapter15_1_a - Chapter 15-1 Capital Structure in a Perfect...

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Chapter 15-1 Capital Structure in a Perfect World

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The Capital-Structure Question The value of a firm is defined to be the sum of the value of the firm’s debt and the firm’s equity. V = D + E The Capital Structure decision can be viewed as how best to slice up a the pie. If how you slice the pie affects the size of the pie, then the capital structure decision matters. 70% Debt 30% Equity
1. What is an optimal capital structure? D = market value of firm’s debt E = market value of firm’s equity V= D + E = market value of firm’s assets Questions: 1. Do shareholders want managers to maximize V or E? 2. What ratio of debt to equity maximizes the shareholders’ interests?

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2. Maximizing firm value versus maximizing stockholder interests Example: J.J. Sprint Co 100 shares selling at \$10 each E 0 = 1000 Initially unlevered D 0 = 0 Firm value: V 0 = 1000 + 0 = 1000 Management of Sprint considers becoming levered Borrow \$500 D 1 = 500 Use \$500 to pay special dividend of \$5 per share Management believes that new firm value V 1 will be either: \$1250, \$1000, or \$750
Example (continued) What is the value of debt and equity with the leverage? How much do shareholders profit/lose from increase in leverage? Key Observation: Conclusion: V 0 = 1,000 V 1 =1,250 V 1 =1,000 V 1 =750 Debt Value 0 500 500 500 Equity Value 1,000 750 500 250 V 1 =1250 V 1 =1000 V 1 =750 Capital gains -250 -500 -750 Dividends 500 500 500 Shareholder profit 250 0 -250

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3. The effect of financial leverage on returns to stockholders: an example Unlevered capital structure (Current) 400,000 shares, price of \$20 No debt Levered capital structure (Proposed) Issue \$4,000,000 in debt, r=10% Use proceeds to repurchase \$4,000,000 of equity Unlevered Levered Assets 8,000,000 8,000,000 Debt 0 4,000,000 Equity 8,000,000 4,000,000 Interest rate 10% 10% Stock price 20 20 Shares outstanding 400,000 200,000
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This note was uploaded on 04/15/2008 for the course BUS 135 taught by Professor Na during the Winter '08 term at UC Riverside.

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chapter15_1_a - Chapter 15-1 Capital Structure in a Perfect...

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