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AEM324 - financial leverage and capital structure policy

AEM324 - financial leverage and capital structure policy -...

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Chapter 17 Financial Leverage and Capital Structure Policy Choosing a capital structure that alters the debt-equity ratio in order to maximize the value of a share of stock o Essentially maximizing the value of the firm as a whole The value of the firm is maximized when the WACC is minimized o The WACC is the appropriate discount rate for the firm’s overall cash flows Values and this rate move in opposite directions A particular debt-equity ratio represents the optimal capital structure or target capital structure if it results in the lowest possible WACC Financial leverage is the extent to which a firm relies on debt EPS is twice as sensitive to changes in EBIT because of financial leverage employed o Issuance of debt reduces net income, but in cases besides that of a recession, ROE and EPS are higher than would be without the debt issue There is a breakeven point when determining where the debt issue would benefit your firm o EPS for both situations (with and without debt) is equal at this point EBIT/outstanding shares = (EBIT – interest expense of debt)/outstanding shares Also called the indifference point; above this level, financial leverage is beneficial, below this point it is not Another way of showing this: the breakeven point is where the unlevered firm has an EBIT equal to the value of net income; the ROE at this point is equal to the interest rate on the debt being considered, so the firm earns just enough to pay for the interest, hence, breaks even Calculations o When new debt is issued for reduction of outstanding shares, total debt/current share price = shares of stock to be bought up; the original shares outstanding – the figure determined above = new amount of outstanding shares The effect of financial leverage depends on the company’s EBIT; when EBIT is relatively high, leverage is beneficial Shareholders are exposed to more risk under a proposed restructuring with more financial leverage because the EPS and ROE are much more sensitive to changes in EBIT in this case Shareholders can adjust the amount of financial leverage by borrowing and lending on their own ( homemade leverage ) o In this way, regardless of whether or not a firm adopts a proposed capital structure, an individual can achieve the same earnings on his/her own o Ex: instead of buying 100 shares at $20 a piece, an individual would borrow $2,000 and buy 200 shares at $20 a piece, increasing earnings even after payment of interest In this case, we knew to borrow $2,000 because the company would have a debt-equity ratio of 1 if they adopted to proposal; since they didn’t the
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individual simply adjusted his debt-equity ratio from 0 to 1 and achieved the same thing The reverse can also happen; if the company adopts a plan and an individual share holder does not want the expected results, he/she can unlever his/her stock and lend the money from the sale of a proportion of the stock M&M proposition 1
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