1class #19page 1Capital Structure Part II(a.k.a. “does debt matter ?”)class #19class #19page 2Today’s plan•Continue our work on capital structure–answer the big question: “does debt matter ???”–examples if time permitsclass #19page 3The 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 #19page 4Effect 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 firmclass #19page 5Effect of taxes (2)•Let’s look at where the operating income goes:EBIT$1,000Interest expense0Pre-tax income1,000Tax expense-350Net income650CF to debt + equity650class #19page 6Effect of taxes (3)•What is the rAor rE?•rA= rE,unlev= 8% + 0.60( 7% ) = 12.20%
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