Lecture 8.pdf - Lecture 8 Capital Structure Theory...

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16-0 Lecture 8 Capital Structure Theory Professor (Dr.) Hao Jiang 1-0
16-1 Key Concepts Understand the effect of financial leverage (i.e., capital structure) on firm earnings M&M Tradeoff Theory
16-2 1. Effects of leverage
16-3 Financial Leverage, EPS, and ROE Current Assets $20,000 Debt $0 Equity $20,000 Debt/Equity ratio 0.00 Interest rate n/a Shares outstanding 400 Share price $50 Proposed $20,000 $8,000 $12,000 2/3 8% 240 $50 Consider an all-equity firm that is contemplating going into debt. (Maybe some of the original shareholders want to cash out.)
16-4 EPS and ROE Under Current Structure Recession Expected Expansion EBIT $1,000 $2,000 $3,000 Interest 0 0 0 Net income $1,000 $2,000 $3,000 EPS $2.50 $5.00 $7.50 ROA 5% 10% 15% ROE 5% 10% 15% Current Shares Outstanding = 400 shares
16-5 EPS and ROE Under Proposed Structure Recession Expected Expansion EBIT $1,000 $2,000 $3,000 Interest 640 640 640 Net income $360 $1,360 $2,360 EPS $1.50 $5.67 $9.83 ROA 1.8% 6.8% 11.8% ROE 3.0% 11.3% 19.7% Proposed Shares Outstanding = 240 shares
16-6 Financial Leverage and EPS (2.00) 0.00 2.00 4.00 6.00 8.00 10.00 12.00 1,000 2,000 3,000 EPS Debt No Debt Break-even point EBIT in dollars, no taxes Advantage to debt Disadvantage to debt
16-7 2. Modigliani &Miller Theorem
16-8 Assumptions of the M&M Model Homogeneous Expectations Homogeneous Business Risk Classes Perpetual Cash Flows Perfect Capital Markets: Perfect competition Firms and investors can borrow/lend at the same rate Equal access to all relevant information No transaction costs No taxes
16-9 Homemade Leverage: An Example Recession Expected Expansion EPS of Unlevered Firm $2.50 $5.00 $7.50 Earnings for 40 shares $100 $200 $300 Less interest on $800 (8%) $64 $64 $64 Net Profits $36 $136 $236 ROE (Net Profits / $1,200) 3.0% 11.3% 19.7% We are buying 40 shares of a $50 stock, using $800 in margin.

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