MGFC10_Chapter 16_Capital Structure Basic Concepts_Notes (Updtaed).pdf - Chapter 16 Capital Structure \u2013 Some Basic Concepts \u2022 The Capital-Structure

MGFC10_Chapter 16_Capital Structure Basic Concepts_Notes (Updtaed).pdf

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Chapter 16: Capital Structure – Some Basic Concepts The Capital-Structure Question and The Pie Theory Maximizing Firm Value versus Maximizing Stockholder Interests Financial Leverage and Firm Value: An Example Modigliani & Miller: Propositions I & II (No Taxes) Modigliani & Miller: Propositions I & II with Taxes Summary and Conclusions 1
The Capital-Structure Question and The Pie Theory 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 = B + S If the goal of the management is to make the firm as valuable as possible, then the firm should pick the debt-equity ratio that makes the pie as big as possible. Value of the Firm S B 2
The Capital-Structure Question There are really two important questions: 1. Why should the stockholders care about maximizing firm value? Perhaps they should be interested in strategies that maximize shareholder value. 2. What is the ratio of debt-to-equity that maximizes the shareholder’s value? As it turns out, changes in capital structure benefit the stockholders if and only if the value of the firm increases. 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 An all-equity firm is considering going into debt. (Maybe some of the original shareholders want to cash out.) 4
EPS and ROE Under Current Capital 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 5
EPS and ROE Under Proposed Capital 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 5% 10% 15% ROE 3% 11.3% 19.7% Proposed Shares Outstanding = 240 shares 6
EPS and ROE Under Both Capital Structures All-Equity 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 Levered 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 5% 10% 15% ROE 3% 11.3% 19.7% Proposed Shares Outstanding = 240 shares 7
FINANCIAL LEVERAGE & EPS INDIFFERENCE EBIT Under two Capital Structures at what EBIT, EPS will be the same EBIT/# of shares without debt = (EBIT-Interest)/# of shares with debt EBIT/400 = (EBIT – 640)/240 Therefore Indifference EBIT = \$1600 8
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 EBI in dollars, no taxes Advantage to debt Disadvantage to debt EBIT
FINANCIAL LEVERAGE & EPS DEGREE OF FINANCIAL LEVERAGE Is a measure of % change in EPS as a result of each % change in EBIT DFL = % Change in EPS/% Change in EBIT If EBIT change by 1%, EPS will change by 1.47% 10 (9.83 5.67) /5.67 1.47 (3000 2000) / 2000 2000 1.47 2000 640 DFL OR EBIT DFL EBIT Interest = = = =
Assumptions of the Modigliani-Miller Model Homogeneous Expectations Homogeneous Business Risk Classes Perpetual Cash Flows

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