15 Capital Structure Decisions

15 Capital Structure Decisions - 15 1 CHAPTER 15 Capital...

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Unformatted text preview: 15 - 1 CHAPTER 15 Capital Structure Decisions: The Basics Impact of leverage on returns Business versus financial risk Capital structure theory Perpetual cash flow example Setting the optimal capital structure in practice 15 - 2 Firm U Firm L No debt $10,000 of 12% debt $20,000 in assets $20,000 in assets 40% tax rate 40% tax rate Consider Two Hypothetical Firms Both firms have same operating leverage, business risk, and EBIT of $3,000. They differ only with respect to use of debt. 15 - 3 Impact of Leverage on Returns EBIT $3,000 $3,000 Interest 1,200 EBT $3,000 $1,800 Taxes (40%) 1 ,200 720 NI $1,800 $1,080 ROE 9.0% 10.8% Firm U Firm L 15 - 4 Why does leveraging increase return? Total dollar return to investors: U: NI = $1,800. L: NI + Int= $1,080 + $1,200 = $2,280. Difference= $480. Taxes paid: U: $1,200; L: $720. Difference = $480. More EBIT goes to investors in Firm L. Equity $ proportionally lower than NI. 15 - 5 Uncertainty about future operating income (EBIT). Note that business risk focuses on operating income, so it ignores financing effects. What is business risk? Probability EBIT E(EBIT) Low risk High risk 15 - 6 Factors That Influence Business Risk Uncertainty about demand (unit sales). Uncertainty about output prices. Uncertainty about input costs . Product and other types of liability . Degree of operating leverage (DOL) . 15 - 7 What is operating leverage, and how does it affect a firm’s business risk? Operating leverage is the use of fixed costs rather than variable costs. The higher the proportion of fixed costs within a firm’s overall cost structure, the greater the operating leverage . (More...) 15 - 8 Higher operating leverage leads to more business risk, because a small sales decline causes a larger profit decline. (More...) Sales $ Rev. TC FC Q BE Sales $ Rev. TC FC Q BE Profit } 15 - 9 Probability EBIT L Low operating leverage High operating leverage EBIT H In the typical situation, higher operating leverage leads to higher expected EBIT, but also increases risk. 15 - 10 Business Risk versus Financial Risk Business risk: Uncertainty in future EBIT. Depends on business factors such as competition, operating leverage, etc. Financial risk: Additional business risk concentrated on common stockholders when financial leverage is used. Depends on the amount of debt and preferred stock financing. 15 - 11 From a shareholder’s perspective, how are financial and business risk measured in the stand-alone sense?...
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15 Capital Structure Decisions - 15 1 CHAPTER 15 Capital...

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