BA103-F04-class19-capitalstructurepart2(6slides) - Todays...

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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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