Chap016s(1)

Chap016s(1) - Financial Leverage and Capital Structure...

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Financial Leverage and Capital Structure Chapter Sixteen 1
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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 Increase leverage by issuing debt and repurchasing outstanding shares Decrease leverage by issuing new shares and retiring outstanding debt 2
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Choosing a Capital Structure What is the primary goal of financial managers? Maximize stockholder wealth We want to choose the capital structure that will maximize stockholder wealth We can maximize stockholder wealth by maximizing firm value or minimizing WACC 3
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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 If we have a really good year, then we pay our fixed cost and we have more left over for our stockholders 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 4
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Example: Financial Leverage, EPS and ROE We will ignore the effect of taxes at this stage What happens to EPS and ROE when we issue debt and buy back shares of stock? Financial Leverage Example 5
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Break-Even EBIT Find EBIT where EPS is the same under both the current and proposed capital structures If we expect EBIT to be greater than the break-even point, then leverage is beneficial to our stockholders If we expect EBIT to be less than the break-even point, then leverage is detrimental to our stockholders 6
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Example: Break-Even EBIT ( 29 $2.00 400,000 800,000 EPS $800,000 EBIT 800,000 2EBIT EBIT 400,000 EBIT 200,000 400,000 EBIT 200,000 400,000 EBIT 400,000 EBIT = = = - = - ú û ù ê ë é = - = Break-even Graph 7
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Capital Structure Theory Modigliani and Miller Theory of Capital Structure Proposition I – firm value Proposition II – WACC The value of the firm is determined by the cash flows to the firm and the risk of the assets Changing firm value Change the risk of the cash flows Change the cash flows 8
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Chap016s(1) - Financial Leverage and Capital Structure...

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