Chapter outlines - Chapter Eleven

Chapter outlines - Chapter Eleven - Chapter 11. DESIGNING A...

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Chapter 11. DESIGNING A CAPITAL STRUCTURE There are two major decisions managers need to be concerned with: they need to decide which projects create the most value and which mix of sources of capital is best for financing the firm’s investments. The opportunities to create value through a change in the mix of debt and equity capital are more limited than those available through the selection of superior investment projects. Too much debt is damaging because the firm will have difficulty in servicing its debt , and too little debt is fiscally inefficient because of the tax deductibility of interest expenses. The question then, is what is the right amount of debt? This chapter examines how managers should combine debt and equity financing to achieve an optimal or target capital structure that maximizes the value of the firm’s assets. After reading this chapter, students should understand: 1. How changes in capital structure affect the firm’s earnings per share, market value, share price, and cost of capital. 2. The trade-offs that are implied in the capital structure decision. 3. How corporate taxes and the costs of financial distress affect the capital structure decision. 4. Why firms in different industries and countries can have different capital structures. 5. The factors, in addition to taxes and financial distress costs , that must be taken into account when establishing an optimal capital structure, including agency costs and the presence of information asymmetry between managers and outside investors. THE CAPITAL STRUCTURE DECISION: NO CORPORATE TAXES AND NO FINANCIAL DISTRESS COSTS This section examines how changes in capital structure affect the firm’s profitability, its market value, its share price, and its cost of capital in a world without corporate taxes or financial distress costs . EFFECTS OF CHANGES IN CAPITAL STRUCTURE ON THE FIRM’S PROFITABILITY (NO TAXES AND NO FINANCIAL DISTRESS COSTS) To see why and how financial leverage affects earnings per share (EPS), we examine the case of the Jolly Bear Company (JBC). The company is currently all-equity financed and its CFO is considering substituting half of the equity for the same amount of debt. Exhibit 11.1 illustrates the effect of a recapitalization decision on the firm’s EPS for three possible scenarios: recession, expected performance, and expansion. Exhibit 11.2 depicts graphically the relationship between earnings before and tax (EBIT) and EPS. 11-1
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The firm’s EPS will increase in the expansion and expected scenarios but will decrease in the recession scenario. Before a decision is made, the risk that EBIT and return on assets (ROA) will be lower than their threshold values must be considered. THE TRADE-OFF BETWEEN PROFITABILITY AND RISK
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This note was uploaded on 05/15/2010 for the course FIN 101 taught by Professor Dodge during the Spring '10 term at Nova Southeastern University.

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Chapter outlines - Chapter Eleven - Chapter 11. DESIGNING A...

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