Chapter 13 adjusted.ppt

Chapter 13 adjusted.ppt - CHAPTER 13 Capital Structure and...

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    13-1 CHAPTER 13 Capital Structure and Leverage Business vs. financial risk Optimal capital structure Operating leverage Capital structure theory
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    13-2 What determines business risk? Uncertainty about demand (sales) Uncertainty about output prices Uncertainty about costs Product, other types of liability Operating leverage
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    13-3 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. If most costs are fixed, hence do not  decline when demand falls, then the  firm has high operating leverage.
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    13-4 What is financial leverage? Financial risk? Financial leverage is the use of debt  and preferred stock. Financial risk is the additional risk  concentrated on common  stockholders as a result of financial  leverage.
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    13-5 Business risk vs. Financial risk Business risk depends on business  factors such as competition, product  liability, and operating leverage. Financial risk depends only on the  types of securities issued. More debt, more financial risk. Concentrates business risk on  stockholders.
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    13-6 An example: Illustrating effects of financial leverage Two firms with the same operating leverage,  business risk, and probability distribution of  EBIT. Only differ with respect to their use of debt  (capital structure). 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
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    13-7 Firm U: Unleveraged                                       Economy                               Bad           Avg.        Good Prob. 0.25 0.50 0.25 EBIT $2,000 $3,000 $4,000 Interest          0          0          0 EBT $2,000 $3,000 $4,000 Taxes (40%)      800   1,200   1,600 NI $1,200 $1,800 $2,400
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    13-8 Firm L: Leveraged                                       Economy                               Bad           Avg.        Good Prob.* 0.25 0.50 0.25 EBIT* $2,000 $3,000 $4,000 Interest   1,200   1,200   1,200 EBT $   800 $1,800 $2,800 Taxes (40%)      320      720   1,120 NI $   480 $1,080 $1,680 *Same as for Firm U.  
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  13-9 Optimal Capital Structure The capital structure (mix of debt, preferred,  and common equity) at which P 0  is  maximized.   Trades off higher E(ROE) and EPS against  higher risk.  The tax-related benefits of  leverage are exactly offset by the debt’s  risk-related costs. The target capital structure is the mix of 
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This note was uploaded on 09/08/2010 for the course BUS 170 at San Jose State University .

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Chapter 13 adjusted.ppt - CHAPTER 13 Capital Structure and...

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