# cs1 - Modigliani and Miller approach is based on the...

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Unformatted text preview: Modigliani and Miller approach is based on the following important assumptions: • There is a perfect capital market. • There are no retained earnings. • There are no corporate taxes. • The investors act rationally. • The dividend payout ratio is 100%. • The business consists of the same level of business risk. Capital Structure Management EBIT-EPS Analysis - used to help determine whether it would be better to finance a project with debt or equity. EPS = (EBIT - I)(1 - t) - P S Capital Structure Management EBIT-EPS Analysis - used to help determine whether it would be better to finance a project with debt or equity. EPS EPS == (EBIT (EBIT -- I)(1 I)(1 -- t)t) -- PP SS I = interest expense, P = preferred dividends, S = number of shares of common stock outstanding. EBIT-EPS Example Our firm has 800,000 shares of common stock outstanding, no debt, and a marginal tax rate of 40%. We need \$6,000,000 to finance a proposed project. We are considering two options: Sell 200,000 shares of common stock at \$30 per share, Borrow \$6,000,000 by issuing 10% bonds. If we expect EBIT to be \$2,000,000: Financing stock debt EBIT 2,000,000 2,000,000 - interest 0 (600,000) EBT 2,000,000 1,400,000 - taxes (40%) (800,000) (560,000) EAT1,200,000 840,000 # shares outst. 1,000,000 800,000 EPS \$1.20 \$1.05 If we expect EBIT to be \$4,000,000: Financing stock debt EBIT 4,000,000 4,000,000 - interest 0 (600,000) EBT 4,000,000 3,400,000 - taxes (40%) (1,600,000) (1,360,000) EAT2,400,000 2,040,000 # shares outst. 1,000,000 800,000 EPS \$2.40 \$2.55 If EBIT is \$2,000,000, common stock financing is best. If EBIT is \$4,000,000, debt financing is best. So, now we need to find a breakeven EBIT where neither is better than the other. EPS 3 If we choose stock financing: stock financing 2 1 0 EBIT \$1m \$2m \$3m \$4m EPS 3 If we choose bond financing: bond financing 2 1 0 EBIT \$1m \$2m \$3m \$4m Breakeven EBIT EPS 3 bond financing stock financing 2 1 0 EBIT \$1m \$2m \$3m \$4m Breakeven Point: Set 2 EPS calculations equal to each other and solve for EBIT: Stock Financing (EBIT-I)(1-t) - P S = Debt Financing (EBIT-I)(1-t) - P S Breakeven Point: Stock Financing (EBIT-I)(1-t) - P = S Debt Financing (EBIT-I)(1-t) - P S (EBIT-0) (1-.40) = (EBIT-600,000)(1-.40) 800,000+200,000 800,000 To refresh your algebra…. Stock Financing .6 EBIT = 1 .48 EBIT = .12 EBIT = Debt Financing .6 EBIT - 360,000 .8 .6 EBIT - 360,000 360,000 EBIT = \$3,000,000 Breakeven EBIT EPS 3 bond financing For EBIT up to \$3 million, stock financing is best. stock financing 2 1 0 EBIT \$1m \$2m \$3m \$4m Breakeven EBIT EPS 3 bond financing For EBIT up to \$3 million, stock financing is best. 2 stock financing For EBIT greater than \$3 million, debt financing is best. 1 0 EBIT \$1m \$2m \$3m \$4m Team Problem: Plan A- all equity: We will start a new firm by selling 1,200,000 shares at \$10 per share. Plan B- levered: issue \$3.5 million in 9% debt and finance the rest with equity at \$10 per share. a) Breakeven EBIT: Stock Financing (EBIT-I) (1-t) - P = S EBIT-0 (1-.50) 1,200,000 Levered Financing (EBIT-I) (1-t) - P S = (EBIT-315,000)(1-.50) 850,000 EBIT = \$1,080,000 Analytical Income Statement Stock Levered EBIT 1,080,000 1,080,000 I 0 (315,000) EBT 1,080,000 765,000 Tax (540,000) (382,500) NI 540,000 382,500 Shares 1,200,000 EPS .45 .45 850,000 b) Breakeven EBIT levered financing EPS .65 stock financing .45 .25 0 EBIT \$.5m \$1m \$1.5m \$2m Breakeven EBIT For EBIT up levered to \$1.08 m, stock EPS financing stock financing .65 financing is best. .45 .25 0 EBIT \$.5m \$1m \$1.5m \$2m Breakeven EBIT For EBIT up levered to \$1.08 m, stock EPS financing stock financing .65 financing is best. For EBIT greater than \$1.08 m, .45 the levered plan is best. .25 0 EBIT \$.5m \$1m \$1.5m \$2m ...
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