CapStr&Lev_AD_ShortVersion

CapStr&Lev_AD_ShortVersion - 1 Leverage& Capital...

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Unformatted text preview: 1 Leverage & Capital Structure 2 Objectives Objectives Why leverage affects shareholder wealth Theories of capital structure Different types of leverage Break even analysis EBIT–EPS analysis 3 Source of raising funds Source of raising funds When company expands, it needs capital. Capital = Financing = Money Where does the source of financing come from? 4 A Firm’s Capital A Firm’s Capital The long term funds it uses to finance its investments. A firm’s capital structure is the mixture of debt and common stock equity it uses to supply this capital 5 Debt has two important advantages: Debt has two important advantages: Interest paid is tax deductible, which lowers debt’s effective cost Debt-holders get a fixed return, so stockholders DO NOT have to share their profits if business is extremely successful 6 Disadvantages of debts Disadvantages of debts The higher the debt ratio, the riskier the company, hence the higher its cost of both debt and equity If company’s operating income is not sufficient to cover interest charges, stockholders will have to make up the shortfall, and if they cannot, bankruptcy will result. 7 When to borrow and when not to borrow? When to borrow and when not to borrow? Companies with less business risk and more stable operating cash flows can take on more debt. Companies with volatile earnings and operating cash flows therefore limit their use of debt. Why? 8 Adding Debt Adding Debt Adding debt to the capital structure increases the volatility of the cash flows, which means the firm’s risk is increased . Increases firm’s financial risk What is business and financial risk? 9 Business risk: Uncertainty about future pre-tax operating income (EBIT) Business risk: Uncertainty about future pre-tax operating income (EBIT) Affected by: Sales volume variability Competition Product diversification Growth prospects Size Operating leverage 10 Financial risk Financial risk The variability or uncertainty of a firm’s earnings per share (EPS) and the increased probability of insolvency that arises when a firm uses financial leverage . Affected by: The use of fixed-cost sources of financing What is operating and financial average? 11 Leverage Leverage Implies the use of fixed costs in a business to magnify earnings Implies that firm is taking risk Operating leverage relates to fixed operating costs firm uses in its operation Financial leverage relates to using of financial sources, carrying fixed financing cost Attempting to increase returns to stockholders 12 13 Probability Distribution of EPS with Different Amounts of Financial Leverage Probability Distribution of EPS with Different Amounts of Financial Leverage Probability Density $2.00 $3.00 50% Debt Financing Zero Debt Financing EPS ($) 14 An Alternative Way to View the Effect of Leverage: An Alternative Way to View the Effect of Leverage: Graph EBIT against EPS for different levels of debt....
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This note was uploaded on 12/12/2011 for the course ECONOMICS 101 taught by Professor Thoman during the Spring '09 term at Abu Dhabi University.

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CapStr&Lev_AD_ShortVersion - 1 Leverage& Capital...

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