Bristow Ent Fin Ch7

Bristow Ent Fin Ch7 - Chapter 7 CAPITAL STRUCTURE AND...

Info iconThis preview shows pages 1–10. Sign up to view the full content.

View Full Document Right Arrow Icon
Chapter 7 CAPITAL STRUCTURE AND LEVERAGE
Background image of page 1

Info iconThis preview has intentionally blurred sections. Sign up to view the full version.

View Full DocumentRight Arrow Icon
2 TRADITIONAL MODELS: “Times Interest Earned” = or “Times Burden Earned” = And more recently, “Times Debt Charges Earned” = CAPITAL  STRUCTURE - TRADITIONAL  APPROACH EBIT INTEREST EBIT INTEREST + SINKING FUND EBIT + DEPRECIATION INTEREST + S.F. + CAP.EXP.
Background image of page 2
3 The idea behind the traditional approach is that if a firm has “Interest coverage” greater than some “norm” - or average for an industry - then their Capital Structure is acceptable. If their coverage ratios were less than the “average” the conclusion would be that the company had too much debt. CAPITAL  STRUCTURE - TRADITIONAL  APPROACH
Background image of page 3

Info iconThis preview has intentionally blurred sections. Sign up to view the full version.

View Full DocumentRight Arrow Icon
4 When this approach was first invented, bonded indebtedness was all quite alike in its terms; the difference in interest rates was not much and there was no required SINKING FUND . A “sinking fund” is an actual cash fund in which the company deposits cash (or the security itself - which takes cash) so that there would be sufficient money to pay off the bond when it matured. Bonds were essentially HOMOGENEOUS CAPITAL  STRUCTURE - TRADITIONAL  APPROACH
Background image of page 4
5 Theoretical approach In 1958, Modigliani and Miller argued that in a world of no taxes, and certain other assumptions, changes in the firm’s capital structure have no effect on the valuation of the firm. Thus, if the value of the firm is V, where V = S + D then if you increase debt - and thus the “risk” of the firm - S declines leaving V unchanged. CAPITAL  STRUCTURE - THEORETICAL  APPROACH
Background image of page 5

Info iconThis preview has intentionally blurred sections. Sign up to view the full version.

View Full DocumentRight Arrow Icon
6 Essentially, M&M argue that capital structure does not really matter, that the “Market” will adjust to whatever capital structure there is. When it comes to “optimal” capital structure, the argument is based on two things: 1) the tax savings associated with interest and 2) the costs of bankruptcy. CAPITAL  STRUCTURE - THEORETICAL  APPROACH
Background image of page 6
7 First, it is important to recognize that debt today is HETEROGENEOUS, NOT HOMOGENEOUS AS ASSUMED IN EARLIER MODELS . You can have many different terms: maturity, interest rate, etc. CAPITAL  STRUCTURE - CASH FLOW APPROACH
Background image of page 7

Info iconThis preview has intentionally blurred sections. Sign up to view the full version.

View Full DocumentRight Arrow Icon
8 CASH FLOW APPROACH : The amount of debt that you can have (max.) is the amount of debt you can service . This is why the HETEROGENEITY of debt is so important. The problem then is How do you determine how much money is available to service debt?” CAPITAL  STRUCTURE - CASH FLOW APPROACH
Background image of page 8
How do you determine how much money is available to service debt? Face Amount of Debt = NOCF'' (Less dividends) that Can Be Serviced i + Sinking Fund – Where NOCF" = NOCF - necessary Discretionary ; the Sinking Fund is expressed as a percentage of principal, and i is the interest rate. CAPITAL  STRUCTURE - CASH FLOW APPROACH
Background image of page 9

Info iconThis preview has intentionally blurred sections. Sign up to view the full version.

View Full DocumentRight Arrow Icon
Image of page 10
This is the end of the preview. Sign up to access the rest of the document.

This note was uploaded on 02/11/2012 for the course BUAD 497 taught by Professor Degravel during the Spring '07 term at USC.

Page1 / 44

Bristow Ent Fin Ch7 - Chapter 7 CAPITAL STRUCTURE AND...

This preview shows document pages 1 - 10. Sign up to view the full document.

View Full Document Right Arrow Icon
Ask a homework question - tutors are online