FIN+4414+-+Capital+Structure+Decisions+-+The+Basics+-+Chapter+16

# FIN+4414+-+Capital+Structure+Decisions+-+The+Basics+-+Chapter+16

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Capital Structure Decisions: The Basics

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Breakeven Analysis Assumptions : Firms A and B each have sales of 100 units with a price of \$5 per unit. Firm B has traded fixed costs for variable costs. Firm B has levered itself by
Breakeven Analysis Firm A Firm B Sales \$500 \$500 Variable Costs -\$350 -\$200 Fixed Costs \$0 -\$150 EBIT \$150 \$150 Interest \$0 -\$60 EBT \$150 \$90 Taxes (40%) -\$60 -\$36 Net Income \$90 \$54 Units 100

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Breakeven Analysis EBIT Breakeven : Q* = [F] / [P - V] S* = [F] / [1 - (V/P)] Net Income Breakeven : Q* = [F + I] / [P - V] S* = [F + I] / [1 - (V/P)]
Breakeven Analysis Firm B EBIT Breakeven : Q* = [\$150] / [\$5 - \$2] Q* = 50 Units S* = [\$150] / [1 - (\$2/\$5)] S* = [\$150] /[.60] = \$250 S* = [50 units] [\$5] = \$250

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Breakeven Analysis Units 50 Firm A Firm B Sales \$250 \$250 Variable Costs -\$175 -\$100 Fixed Costs \$0 -\$150 EBIT \$75 \$0 Interest \$0 -\$60 EBT \$75 -\$60 Taxes (40%) -\$30 \$24 Net Income \$45 -\$36
Breakeven Analysis Firm B Net Income Breakeven : Q* = [\$150 + \$60] / [\$5 - \$2] Q* = 70 Units S* = [\$150 + \$60] / [1 - (\$2/\$5)] S* = [\$210] /[.60] = \$350 S* = [70 units] [\$5] = \$350

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Breakeven Analysis Units 70 Firm A Firm B Sales \$350 \$350 Variable Costs -\$245 -\$140 Fixed Costs \$0 -\$150 EBIT \$105 \$60 Interest \$0 -\$60 EBT \$105 \$0 Taxes (40%) -\$42 \$0 Net Income \$63 \$0
Capital Structure and Risk Factors to consider Business risk Financial risk (leverage) Need for financial flexibility Tax position Managerial perspective Conservative Aggressive

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Capital Structure and Risk r S = r RF + [r M - r RF ][ β L ] β L = β U + β U (1-T)(D/E) r S = r RF + [r M - r RF ][ β U ] + [r M - r RF ][ β U ](1-T)(D/E)
Capital Structure and Risk r S = r RF + Business risk premium + Financial risk premium Business risk concerns the uncertainty inherent in EBIT.

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Business Risk 0 EBIT Probability Lower Risk Higher Risk
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FIN+4414+-+Capital+Structure+Decisions+-+The+Basics+-+Chapter+16

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