7Capital Structure Theory2

7Capital Structure Theory2 - CapitalStructureTheory 1...

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Capital Structure Theory 1
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Firm Objective Maximize Value Capital Budgeting Decision Invest in projects that add value to the firm Financing Decision Maximize firm  value through optimal capital structure Payout Decision Return excess cash to investors to maximize shareholder wealth 2
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Financing Decision Maximize firm value through optimal capital structure Implement a capital structure with the optimal mix of equity and debt Issue the right kind of debt and equity securities to match assets 3
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What is Capital Structure? Capital structure is how our firm chooses to finance  its investments Debt - Debt Common Stock Preferred Stock      Equity Does it matter what capital structure we use? Some say yes Lower cost of debt, tax advantages, etc Some say no Slicing the same pie… assets are worth what they are worth,  and the financing decisions are irrelevant So… does it matter?  Probably 4
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Why do we care about capital  structure? It changes cash flows and returns to  equityholders Equity $10.00 $7.50 $5.00 5% Debt $0.00 $2.50 $5.00 Debt-to-Equity 0 0.33 1.0 EBIT $2.00 $2.00 $2.00 Interest $0.00 $0.125 $0.25 Earnings b/f  Taxes $2.00 $1.875 $1.75 Taxes (40%) $0.80 $0.75 $0.70 Net Income $1.20 $1.125 $1.05 Return on Equity 12% 15% 21% Dividend (50%) $0.60 $0.5625 $0.525 Dividend Yield 6% 7.5% 10.5% Here, we had  good performance  and increased  leverage causes  equity returns to  be higher 5
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Another Example of  Leverage’s Effect on Returns Equity $10.00 $7.50 $5.00 5% Debt $0.00 $2.50 $5.00 Debt-to-Equity 0 0.33 1.0 EBIT $0.50 $0.50 $0.50 Interest $0.00 $0.125 $0.25 Earnings b/f  Taxes $0.50 $0.375 $0.25 Taxes (40%) $0.20 $0.15 $0.10 Net Income $0.30 $0.225 $0.15 Return on Equity 3% 3% 3% Dividend (50%) $0.15 $0.112 5 $0.075 Here, we had average  performance and  leverage has no effect  on the returns of  shareholders 6
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Last Example of Leverage’s  Effect on Returns Equity $10.00 $7.50 $5.00 5% Debt $0.00 $2.50 $5.00 Debt-to-Equity 0 0.33 1.0 EBIT -$1.00 -$1.00 -$1.00 Interest $0.00 $0.125 $0.25 Earnings b/f  Taxes -$1.00 -$1.125 -$1.25 Taxes (40%) -$0.40 -$0.45 -$0.50 Net Income -$0.60 -$0.675 -$0.75 Return on Equity -6% -9% -15% Dividend (50%) Maybe no dividends paid,  but future dividends lower  for higher leverage Dividend Yield Here, we had bad  performance and  leverage decreases the  returns of shareholders Bottom line: using debt  (leverage) amplifies (or  “levers”) the effect of good  and bad operating  performance on  equityholder returns 7
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Debt and Equity Ratios Throughout our discussion of capital  structure, we will use two ratios frequently E D D + = Ratio Debt E D Ratio Equity - to - Debt = Note: Debt Ratio is always between 0 and 1 Note: Debt-to-Equity Ratio can range from 0 to infinity 8
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This note was uploaded on 09/22/2011 for the course FINANCE 117 taught by Professor Tingtingque during the Summer '11 term at University of Iowa.

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