Class 17

Class 17 - Debtvs.Equity bydebtvs.equity assets...

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Capital Structure Policy Debt vs. Equity
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What is Capital Structure? Capital structure relates to how much  the company finances its operations  by debt vs. equity 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/or repurchasing  outstanding shares
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Optimal Capital Structure As the goal of management is  maximizing shareholder wealth, the  optimal capital structure should be the  one maximizing the market value of  the company Minimizing WACC would be another  way of looking at it as a lower cost of  capital means higher NPVs
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Effect of Leverage When we increase the amount of debt  financing, we increase the fixed  interest expense that has to be paid If the company has a really good year,  then it pays the fixed costs and has  money left over for the stockholders  If it has a really bad year, it still has to  pay the fixed costs and has less left  over for the stockholders Leverage amplifies the variation in 
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Effect of Leverage – Example  Current Structure Proposed Structure Assets $5,000,000 $5,000,000 Debt $0 $2,500,000 Equity $5,000,000 $2,500,000 Debt/Equity Ratio 0 1 Share Price $10 $10 Shares Outstanding 500,000 250,000 Interest rate N/A 10%
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Current Capital Structure: No Debt Recession Expected Expansion EBIT $300,000 $650,000 $1,000,000 Interest 0 0 0 Net Income $300,000 $650,000 $1,000,000 ROE 6.00% 13.00% 20.00% EPS $0.60 $1.30 $2.00
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Class 17 - Debtvs.Equity bydebtvs.equity assets...

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