Chapter Outlines (doc)

Chapter Outlines (doc) - Capital Structure-Value of a Firm...

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Capital Structure: -Value of a Firm = PV of expected future cash flows, discounted at its WACC. -WACC depends on the % of debt & equity used by the firm; its capital structure. -The only way a decision can change a firm’s value is by affecting either cash flows or the cost of capital. Debt Increases the Cost of Stock (k s ) -Debtholders have a prior claim on the cash flows than do the stockholders, who are entitled to the residual cash flow after debtholders have been paid. Debt Reduces the Taxes a Firm Pays -If cash flows are a pie, three groups get slices of the pie: first slice goes to the gov’t in the form of taxes, second to the debtholders, and third to the stockholders. -Companies can deduct interest expenses from taxable income, reducing the gov’t piece of pie and leaves more pie for Risk of Bankruptcy Increases the Cost of Debt (k d ) -As debt increases, risk of bankruptcy goes up because the firm owes more – and thus has more liabilities. -Higher bankruptcy risk leads to debtholders requiring a higher return, increasing the cost of debt. Net Effect on WACC -Should be clear that changing the capital structure affects all variables in the WACC equation, it’s not easy to say whether the changes increase or decrease the WACC. Business Risk: -Return on Invested Capital measures business risk on a stand-alone basis -ROIC = NOPAT / Capital = EBIT (1 – T) / Capital - Business risk is the risk that common stockholders would face if the firm had no debt. -Business Risk depends on demand variability, sales price variability, input cost variability, ability to adjust output prices for changes in input costs, ability to develop new products, foreign risk exposure, & operating leverage. - Operating Leverage is high: implies that a small change in sales results in a large change in EBIT. -Can calculate the breakeven quantity of sales by recognizing that operating breakeven occurs when EBIT = 0.
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This note was uploaded on 12/07/2009 for the course FIRE 312 taught by Professor Salandro during the Spring '09 term at VCU.

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Chapter Outlines (doc) - Capital Structure-Value of a Firm...

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