chapter 14 - Chapter 14 Debt policy COPYRIGHTZHULI 1...

Info iconThis preview shows pages 1–14. Sign up to view the full content.

View Full Document Right Arrow Icon
COPYRIGHT©ZHULI 1 Chapter 14 Debt policy
Background image of page 1

Info iconThis preview has intentionally blurred sections. Sign up to view the full version.

View Full DocumentRight Arrow Icon
COPYRIGHT©ZHULI 2 Objectives 1. Analyze the effect of debt finance on the risk and required return of equityholders 2. Appreciate the advantages and disadvantages of debt finance 3. Cite the various costs of financial distress 4. Explain why the debt-equity mix varies across firms and across industries 5. Summarize the bankruptcy procedures for firms that cannot pay their creditors
Background image of page 2
COPYRIGHT©ZHULI 3 Content How borrowing affects value in a tax-free economy Capital structure and corporate taxes Costs of financial distress Explaining financing choices Bankruptcy procedures
Background image of page 3

Info iconThis preview has intentionally blurred sections. Sign up to view the full version.

View Full DocumentRight Arrow Icon
COPYRIGHT©ZHULI 4 Capital structure : the mix of long-term debt and equity financing The value of those cash flows determines the value of the firm and therefore determines the aggregate value of all the firm’s outstanding debt and equity securities. If the firm changes its capital structure, say, by using more debt and less equity financing, overall value should not change.
Background image of page 4
COPYRIGHT©ZHULI 5 MM proposition: When there are no taxes and capital markets function well, the market value of a company does not depend on its capital structure. In other words, financial managers cannot increase value by changing the mix of securities used to finance the company.
Background image of page 5

Info iconThis preview has intentionally blurred sections. Sign up to view the full version.

View Full DocumentRight Arrow Icon
COPYRIGHT©ZHULI 6 MM’s argument Restructuring : process of changing the firm’s capital structure without changing its assets
Background image of page 6
COPYRIGHT©ZHULI 7 How borrowing affects earnings per share Borrowing increases earnings per share (EPS) when operating income is greater than $100,000 but reduces it when operating income is less than $100,000.
Background image of page 7

Info iconThis preview has intentionally blurred sections. Sign up to view the full version.

View Full DocumentRight Arrow Icon
COPYRIGHT©ZHULI 8 MM’s proposition I (Debt irrelevance proposition): The value of a firm is unaffected by its capital structure.
Background image of page 8
COPYRIGHT©ZHULI 9 How borrowing affects risk and return
Background image of page 9

Info iconThis preview has intentionally blurred sections. Sign up to view the full version.

View Full DocumentRight Arrow Icon
COPYRIGHT©ZHULI 10 Debt financing does not affect the operating risk or, equivalently, the business risk of the firm Operating risk or business risk : risk in firm’s operating income But with less equity outstanding, a change in operating income has a greater impact on earnings per share Financial leverage : debt financing to amplify the effects of changes in operating income on the returns to shareholders Financial risk : risk to shareholders resulting from the use of debt
Background image of page 10
COPYRIGHT©ZHULI 11 Debt finance does not affect the operating risk but it does add financial risk. With only half the equity to absorb the same amount of operating risk, risk per share must double
Background image of page 11

Info iconThis preview has intentionally blurred sections. Sign up to view the full version.

View Full DocumentRight Arrow Icon
COPYRIGHT©ZHULI 12 Leverage increases the expected return to shareholders, but it also increases the risk. The two effects cancel, leaving shareholder value unchanged
Background image of page 12
13 Debt and the cost of equity MM’s proposition I states that the firm’s choice of capital structure does not affect the firm’s operating income or the value of its assets. So r assets , the expected return on the package of debt and equity, is unaffected. However, we have just seen that leverage does increase the
Background image of page 13

Info iconThis preview has intentionally blurred sections. Sign up to view the full version.

View Full DocumentRight Arrow Icon
Image of page 14
This is the end of the preview. Sign up to access the rest of the document.

Page1 / 44

chapter 14 - Chapter 14 Debt policy COPYRIGHTZHULI 1...

This preview shows document pages 1 - 14. Sign up to view the full document.

View Full Document Right Arrow Icon
Ask a homework question - tutors are online