ECO359S-4 - ECO359 Lecture 4 Capital Structure and the Cost...

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1 ECO359 – Lecture 4 Capital Structure and the Cost of Capital Ata Mazaheri
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2 Lecture Outline The Capital-Structure Question and The Pie Theory Maximizing Firm Value versus Maximizing Stockholder Interests Financial Leverage and Firm Value: An Example Modigliani and Miller: Proposition II (No Taxes) Taxes
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3 The Capital-Structure Question and The Pie Theory The value of a firm is defined to be the sum of the value of the firm’s debt and the firm’s equity. V = B + S Value of the Firm S B If the goal of the management of the firm is to make the firm as valuable as possible, then the firm should pick the debt-equity ratio that makes the pie as big as possible.
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4 The Capital-Structure Question There are really two important questions: 1. Why should the stockholders care about maximizing firm value? Perhaps they should be interested in strategies that maximize shareholder value. 2. What is the ratio of debt-to-equity that maximizes the shareholder’s value? As it turns out, changes in capital structure benefit the stockholders if and only if the value of the firm increases.
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5 Financial Leverage, EPS, and ROE Current Assets $20,000 Debt $0 Equity $20,000 Debt/Equity ratio 0.00 Interest rate n/a Shares outstanding 400 Share price $50 Proposed $20,000 $8,000 $12,000 2/3 8% 240 $50 Consider an all-equity firm that is considering going into debt. (Maybe some of the original shareholders want to cash out.)
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6 EPS and ROE Under Current Capital Structure Recession Expected Expansion EBIT $1,000 $2,000 $3,000 Interest 0 0 0 Net income $1,000 $2,000 $3,000 EPS $2.50 $5.00 $7.50 ROA 5% 10% 15% ROE 5% 10% 15% Current Shares Outstanding = 400 shares
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7 EPS and ROE Under Proposed Capital Structure Recession Expected Expansion EBIT $1,000 $2,000 $3,000 Interest 640 640 640 Net income $360 $1,360 $2,360 EPS $1.50 $5.67 $9.83 ROA 5% 10% 15% ROE 3% 11% 20% Proposed Shares Outstanding = 240 shares
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8 EPS and ROE Under Both Capital Structures Levered Recession Expected Expansion EBIT $1,000 $2,000 $3,000 Interest 640 640 640 Net income $360 $1,360 $2,360 EPS $1.50 $5.67 $9.83 ROA 5% 10% 15% ROE 3% 11% 20% Proposed Shares Outstanding = 240 shares All-Equity Recession Expected Expansion EBIT $1,000 $2,000 $3,000 Interest 0 0 0 Net income $1,000 $2,000 $3,000 EPS $2.50 $5.00 $7.50 ROA 5% 10% 15% ROE 5% 10% 15% Current Shares Outstanding = 400 shares %) 8 % 10 ( 3 2 % 10 3 % 34 ) ( - + = = s r E Note:
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9 Financial Leverage and EPS (2.00) 0.00 2.00 4.00 6.00 8.00 10.00 12.00 1,000 2,000 3,000 EPS Debt No Debt Break-even point EBI in dollars, no taxes Advantage to debt Disadvantage to debt EBIT
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10 Assumptions of the Modigliani-Miller Model Homogeneous Expectations Homogeneous Business Risk Classes Perpetual Cash Flows Perfect Capital Markets: Perfect competition Firms and investors can borrow/lend at the same rate Equal access to all relevant information No transaction costs No taxes
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11 Homemade Leverage: An Example Recession
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This note was uploaded on 07/18/2010 for the course LIFE SCIEN eco359 taught by Professor Recio during the Summer '10 term at University of Toronto.

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ECO359S-4 - ECO359 Lecture 4 Capital Structure and the Cost...

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