chapter 16 - Chapter 16 Capital Structure: Basic Concepts...

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Chapter 16 Capital Structure: Basic Concepts Lecture Notes for Actsc 372 - Fall 2011 Ken Seng Tan Department of Statistics and Actuarial Science University of Waterloo K.S. Tan/Actsc 372 F11 Chapter 16Capital Structure: Basic Concepts – p. 1/37 Chapter Outline The Capital-Structure Question and the Pie Model The Impact of Financial Leverage on the Firm Value EPS ROE Modigliani and Miller (MM): Propositions I and II No Taxes With Taxes Nobel Laureates 1985: Franco Modigliani “For his pioneering analysis of savings and financial markets." 1990: Merton Miller “For his fundamental contributions to the theory of corporate finance." K.S. Tan/Actsc 372 F11 Chapter 16Capital Structure: Basic Concepts – p. 2/37 The Capital Structure Questions Recall that the firm’s mix of securities is known as its capital structure Three key questions: What should the management do to maximize shareholders’ interest? Does a change in capital structure affect the value of the firm? Does it exist an optimal debt to equity ratio ( B/S ) or debt to as- set ratio ( B/V ) that maximizes shareholders’ interest? Assume the firm’s securities consist of debt and equity so that the balance sheet ( market values ) of the firm: Assets (V) Debt (B) Equity (S) The Pie Model Equity Debt V = B + S K.S. Tan/Actsc 372 F11 Chapter 16Capital Structure: Basic Concepts – p. 3/37
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Management’s Objective vs Shareholders’ Interests Management is appointed by the shareholders and hence should attempt to maximize shareholders’ interests this in turn should maximize market values of the equity Maximizing Shareholders’ Interests ± Maximizing Equity ± Maximizing Firm Value Since debt (interest) payments are fixed shareholders only receive the residual cash flows K.S. Tan/Actsc 372 F11 Chapter 16Capital Structure: Basic Concepts – p. 4/37 A firm is considering capital restructuring by issuing debt to repurchase half of its stock: Current Proposed Assets 10,000 10,000 Debt 0 5,000 Equity 10,000 5,000 B/S ratio 0 1 Share price $10 $10 Shares outstanding 1,000 500 Interest rate n/a 10% Current Rec. Expected Expansion EBIT 500 1,500 2,000 EPS 0.5 1.50 2.00 ROE/ROA 5% 15% 20% Proposed Rec. Expected Expansion EBIT 500 1,500 2,000 Interest 500 500 500 Equity earnings 0 1,000 1,500 EPS 0.0 2.0 3.0 ROE 0% 20% 30% K.S. Tan/Actsc 372 F11 Chapter 16Capital Structure: Basic Concepts – p. 5/37 Break-Even Analysis EPS EBIT 0 500 b break-even point 1000 1 all equity B/S = 1 adv. to debt disadv. to debt 2 1.5 Is leverage always beneficial to the shareholders? It depends on EBIT EBIT > break-even point, EBIT < break-even point, ROE In any case, financial leverage increases the volatility of EPS and ROE, increases the risk of equity (higher slope) K.S. Tan/Actsc 372 F11 Chapter 16Capital Structure: Basic Concepts – p. 6/37
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Modigliani and Miller (1958) Assumptions: Perfect capital markets: no transaction costs
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chapter 16 - Chapter 16 Capital Structure: Basic Concepts...

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