FINS1613S1Yr2011Wk11CapStructureSingles

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FINS1613S12011 Kyung Hwan Shim 1 Topic: Financial Leverage & Capital Structure Policy Lecture 11: Objectives Examine the effect of financial leverage on EPS, ROE and stock returns. Explain the concept of “homemade leverage”. Develop and explain Modigliani and Miller’s (M&M) Propositions I, II with and without bankruptcy and taxes. Determine the effect of a change in capital structure on R A , β A , R E , β E , R D and β D under M&M Prop. I, II. Describe how the optimal capital structure is determined by the tradeoff between tax savings and bankruptcy costs.
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FINS1613S12011 Kyung Hwan Shim 2 • Financial Leverage is the extent to which a company is committed to fixed charges related to interest payments. Capital Structure: The mix of debt and equity that makes up a company’s total market value. The debt to equity ratio D/E: market value of outstanding debt divided by the marketvalue of equity. The debt to market value ratio D/V: D/V= D/(D+E) These previous measures are measured using market value of equity and debt. If it is difficult to obtain the market value of debt, use book values. What is Financial Leverage?
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FINS1613S12011 Kyung Hwan Shim 3 Goal: show how financial leverage works through EPS and ROE. Currently the firm has no debt. The proposal is to issue debt and use the proceeds to buy back equity (restructuring). Ignore depreciation and taxes issues. Keep share price fixed for now. The Effect of Financial Leverage: An Example
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FINS1613S12011 Kyung Hwan Shim 4 The Effect of Financial Leverage Cont’d: An Example
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FINS1613S12011 Kyung Hwan Shim 5 We can conclude that: • The effect of financial leverage depends upon EBIT when EBIT is high, financial leverage raises ROE and EPS when EBIT is low, financial leverage lowers ROE and EPS A high leverage firm has higher highs and lower lows in ROE and EPS than a low leveragefirm. The variability of ROE and EPS is increasing with financial leverage Overall : higher financial leverage magnifies the effect of changes in EBIT on ROE and EPS. Using more debt makes ROE and EPS more risky . Consequently, higher leverage also means higher risks to stock holders. The Effect of Financial Leverage Cont’d
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FINS1613S12011 Kyung Hwan Shim 6 Corporate Borrowing and Homemade Leverage Homemade leverage: the use of personal borrowing/lending to change the overall amount of financial leverage to which the individual is exposed. Example: Suppose the firm did not change its capital structure. We will show that investors can replicate the returns from the proposed capital structure byborrowing on their own. Suppose a shareholder wants to invest $100 in the firm, and prefers the proposed rather than the current capital structure. If the proposed capital structure is not adopted, he buys 5 shares with his own money, and additional 5 shares by borrowing $100 at 10% interest. Sohe replicates the returns under the proposed capital structure while the cost of the investment is the same.
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FINS1613S12011 Kyung Hwan Shim 7 Homemade Leverage: An Example
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FINS1613S12011 Kyung Hwan Shim 8
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