Chapter_16_FA311_US2011_SS

Chapter_16_FA311_US2011_SS - Click to edit Master title...

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Unformatted text preview: Click to edit Master title style 12/29/11 1 12/29/11 Chapter 16 Financial Leverage and Capital Structure Policy Click to edit Master title style 12/29/11 2 12/29/11 Key Concepts and Skills • Understand the effect of financial leverage on cash flows and the cost of equity • Understand the impact of taxes and bankruptcy on capital structure choice • Understand the basic components of the bankruptcy process Click to edit Master title style 12/29/11 3 12/29/11 Capital Restructuring • We are going to look at how changes in capital structure affect the value of the firm, all else equal • Capital restructuring involves changing the amount of leverage a firm has without changing the firm’s assets • The firm can increase leverage by issuing debt and repurchasing outstanding shares of stock • The firm can decrease leverage by issuing new shares of stock and retiring outstanding debt Click to edit Master title style 12/29/11 4 12/29/11 Choosing a Capital Structure • What is the primary goal of financial managers? – Maximize stockholder wealth • We want to choose the capital structure that will maximize stockholder wealth • We can maximize stockholder wealth by maximizing the value of the firm or minimizing the WACC Click to edit Master title style 12/29/11 5 12/29/11 Example: Financial Leverage, EPS and ROE – Part I • We will ignore the effect of taxes at this stage • What happens to EPS and ROE when we issue debt and buy back shares of stock? Click to edit Master title style 12/29/11 6 12/29/11 Example: Financial Leverage, EPS and ROE – Part I Click to edit Master title style 12/29/11 7 12/29/11 The Effect of Leverage • How does leverage affect the EPS and ROE of a firm? • When we increase the amount of debt financing, we increase the fixed interest expense • If we have a really good year, then we pay our fixed cost and we have more left over for our stockholders • If we have a really bad year, we still have to pay our fixed costs and we have less left over for our stockholders • Leverage amplifies the variation in both EPS and ROE Reminder: in a restructuring effort, if we increase the amount of debt, we are implicitly decreasing the amount of equity. Click to edit Master title style 12/29/11 8 12/29/11 Example: Financial Leverage, EPS and ROE – Part II • Variability in ROE – Current: ROE ranges from 6% to 20% – Proposed: ROE ranges from 2% to 30% • Variability in EPS – Current: EPS ranges from $0.60 to $2.00 – Proposed: EPS ranges from $0.20 to $3.00 • The variability in both ROE and EPS increases when financial leverage is increased Click to edit Master title style 12/29/11 9 12/29/11 Financial Leverage and EPS Note: the slope of the dotted line (levered strategy) is steeper. This is because in the levered situation there are fewer shares outstanding and, consequently, a small increase in EBIT generates a bigger increase in EPS compared to the unlevered situation. Click to edit Master title style...
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Chapter_16_FA311_US2011_SS - Click to edit Master title...

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