Ch 17 - Ch 17 Financial Leverage and Capital Structure 1....

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Unformatted text preview: Ch 17 Financial Leverage and Capital Structure 1. Capital structure question Financial managers want to set up a capital structure that will maximize the firm and stock value. Changing capital structure influences the cost of capital. Basing on discounted cash flow approach, it is clear that the minimum level of cost of capital would maximize the value of firm. 1) The Effect of Financial Leverage. Def of financial leverage: the extent to which a firm relies on debt. The more debt financing a firm uses in its capital structure, the more financial leverage it employs. Why it is important to firm value or stock value? Ex) Current Proposed Assets 8,000,000.00 $ 8,000,000.00 $ Debt- $ 4,000,000.00 $ Equity 8,000,000.00 $ 4,000,000.00 $ Debt-equity ratio 1 Share price 20.00 $ 20.00 $ Share outstanding 400000 200000 Interest rate 10% 10% Current Capital Structure: No debt Recession Expected Expansion EBIT 500,000.00 $ 1,000,000.00 $ 1,500,000.00 $ Interest- $ - $ - $ Net Income 500,000.00 $ 1,000,000.00 $ 1,500,000.00 $ ROE 6.25% 12.50% 18.75% EPS 1.25 $ 2.50 $ 3.75 $ Current Capital Structure: Debt of $4 million Recession Expected Expansion EBIT 500,000.00 $ 1,000,000.00 $ 1,500,000.00 $ Interest 400,000.00 $ 400,000.00 $ 400,000.00 $ Net Income 100,000.00 $ 600,000.00 $ 1,100,000.00 $ ROE 1.25% 7.50% 13.75% EPS 0.50 $ 3.00 $ 5.50 $ Lessons: (1) Variability of EPS and ROE is much larger under the proposed capital structure with debts, more risk. (2) The effect of financial leverage depends on the companys EBIT. When EBIT is relatively high, leverage is beneficial. 2) Homemade leverage: The use of personal borrowing to change the overall financial leverage to which the individual is expected. Ex) with the previous example, Assume two cases. Investors A an dB have $2000. First one is that investor A buys 100 shares of a firm with debts. Second one is that investor B buys 200 shares of a firm without debts and borrows $2000 at 10%....
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This note was uploaded on 02/23/2010 for the course FIN 81341 taught by Professor Yang during the Spring '10 term at CSU San Bernardino.

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Ch 17 - Ch 17 Financial Leverage and Capital Structure 1....

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