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Unformatted text preview: Chapter 16 Financial Leverage and Capital Structure Policy Slide 16  1 Key Concepts and Skills ¡ Understand the effect of financial leverage on cash flows, and on EPS and ROE ¡ Understand the impact of taxes and bankruptcy on capital structure choice ¡ Introduction of M&M Propositions with or without corporate taxes Slide 16  2 Capital Restructuring ¡ We are going to look at how changes in capital structure affect the value of the firm, all else equal. Capital restructuring involves changing the amount of leverage a firm has without changing the firm’s assets. The firm can increase leverage by issuing debt and repurchasing outstanding shares. The firm can decrease leverage by issuing new shares and retiring outstanding debt. Slide 16  3 Choosing a Capital Structure ¡ The primary goal of financial managers To maximize stockholder wealth (or the firm value) The value of the firm can be maximized by choosing the capital structure (i.e., by minimizing the WACC) ¾ The WACC is the appropriate discount rate for the risk of the firm’s assets. ¾ We find the value of the firm by discounting the firm’s expected future cash flows at the discount rate. ¾ Since value and discount rate move in opposite directions, firm value will be maximized when WACC is minimized. Slide 16  4 The Effect of Leverage ¡ How does leverage affect the EPS and ROE of a firm? When we increase the amount of debt financing, we increase the fixed interest expense. As a result, ¾ If we have a really good year, then we pay our fixed cost and we have more left over for our stockholders. ¾ If we have a really bad year, we still have to pay our fixed costs and we have less left over for our stockholders. Leverage amplifies the variation in both EPS and ROE Slide 16  5 Example : Ignoring the effect of tax, what is the effect of following capital restructuring on EPS and ROE? (Same conclusion can be drawn if tax is considered, but the analysis will be more tedious.) The Effect of Leverage 10% NA Interest rate $2,500,000 $0 Debt $2,500,000 $5,000,000 Equity 1 Debt/Equity ratio $10 $10 Share price Proposed Current 250,000 500,000 Shares outstanding $5,000,000 $5,000,000 Assets Slide 16  6 The Effect of Leverage $1.60 16% $400,000 $250,000 $1.30 13% $650,000 $0 $650,000 Expected $3.00 $0.20 EPS 30% 2% ROE $750,000 $50,000 Net income $250,000 $250,000 Interest Proposed capital structure: Debt = $2.5 million Current capital structure: No debt $0 $0 Interest $1,000,000 $300,000 Net income 20% 6% ROE Expansion Recession $2.00 $0.60 EPS $1,000,000 $300,000 EBIT Slide 16  7 ¡ Some Observations The variability in both ROE and EPS increases when financial leverage is increased....
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This note was uploaded on 04/18/2011 for the course FINA 1003 taught by Professor Lin during the Fall '11 term at HKU.
 Fall '11
 Lin
 Bankruptcy, Leverage

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