CH-16 - Business Risk: R A , depends on the firms assets...

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1 GSB 531 Managerial Finance Chapter 16 Financial Leverage and Capital Structure Policy Capital Structure • Capital Structure: debt-equity ratio • Implications: cost of capital, value of the firm. • A simplified case • Taking taxes into consideration • Taking bankruptcy into consideration Effect of Financial Leverage
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2 Effect of Financial Leverage • Proposition I: A firm’s overall cost of capital is independent of the firm’s capital structure. • What about the value of the firm ??? • Proposition II: A firm’s cost of equity capital is a positive linear function of the firm’s capital structure. Business and Financial Risk •R E = R A + (R A -R D ) * (D/E)
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Unformatted text preview: Business Risk: R A , depends on the firms assets and operations Financial Risk: (R A - R D ) * (D/E), depends on the firms capital structure Financial Risk rises when there is more borrowing 3 M&M Proposition II Proposition II with Tax Bankruptcy Firms or creditors bring petitions to a federal court for bankruptcy. Chapter 7: liquidation, priority rules, debt holders before stock holders Chapter 11: reorganization Direct Bankruptcy Costs: legal and administrative expenses Indirect Bankruptcy Costs: costs in trying to avoid bankruptcy, selling assets, cutting operations 4 Prop. II with Tax and Bankruptcy...
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CH-16 - Business Risk: R A , depends on the firms assets...

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