BA103-F04-class19-capitalstructurepart2(6slides)

BA103-F04-class19-ca - Todays plan Continue our work on capital structure answer the big question does debt matter examples if time permits Capital

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1 class #19 page 1 Capital Structure Part II (a.k.a. “does debt matter ?”) class #19 class #19 page 2 Today’s plan • Continue our work on capital structure – answer the big question: “does debt matter ???” – examples if time permits class #19 page 3 The big question • Can changing the RHS (right hand side) of the balance sheet affect the value of the LHS of the balance sheet? • Can the CFO of a company change the market value of the firm ? Assets Debt Equity class #19 page 4 Effect of taxes • We will now look at another firm with operating profit of $1,000 per year • Profits paid out as dividends at the end of every year • The government taxes profits at a rate of 35% • Asset beta is 0.60 • risk free rate is 8% • market risk premium is 7% • Begin by looking at an unlevered firm class #19 page 5 Effect of taxes (2) • Let’s look at where the operating income goes: EBIT $1,000 Interest expense 0 Pre-tax income 1,000 Tax expense -350 Net income 650 CF to debt + equity 650 class #19 page 6 Effect of taxes (3) • What is the r A or r E ? •r A = r E,unlev = 8% + 0.60( 7% ) = 12.20%
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2 class #19 page 7 Effect of taxes (4) • The pie now has a new claimant (there is no debt in our unlevered firm): Equity Gov’t 328 , 5 $ 1220 . 0 650 r 650 r 650 MV MV A unlev , E E F = = = = = class #19 page 8 Effect of taxes (5) • We will now compare the unlevered firm to a levered firm. Let’s assume the levered firm has borrowed $1,000 at a rate of 8% (riskless debt for simplicity) • Let’s assume that $1,000 = (D/V) = 18% – warning, this is not technically correct – we will talk about solving for the exact percentage during the next class • What is the new r E (levered) ?
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This note was uploaded on 12/06/2011 for the course UGBA 103 taught by Professor Berk during the Fall '07 term at University of California, Berkeley.

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BA103-F04-class19-ca - Todays plan Continue our work on capital structure answer the big question does debt matter examples if time permits Capital

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