08Capital+Structure

08Capital+Structure - CapitalStructure Fromlasttime...

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Capital Structure
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From last time Modigliani-Miller Theorem Market efficiency, Symmetric information No Taxes No transactions or bankruptcy costs Hold constant the firm’s investment policies  The value of a firm is independent of its capital  structure.  Financing decisions do not matter
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Using MM Sensibly Not real world. How does financing change the size of the pie? MM exposes some fallacies WACC EPS
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WACC Fallacy The Fallacy: Debt is better because debt is  cheaper than equity. Because debt is safer than equity, investors  demand a lower return for holding debt than  for holding equity. True So, companies should always finance  themselves with debt because they have to  give away less debt returns to the investors.  False
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EPS Fallacy The Fallacy: Debt is better when it makes EPS go  up.  EPS can go up (or down) when a company  increases its leverage. True  Companies should choose their financial policy  to maximize their EPS False
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EPS Fallacy: Example A firm is a portfolio of debt and equity   Therefore. . . Assets Liab & Eq
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EPS Fallacy: Example Asset risk is determined by the type of projects,  not how the projects are financed. 
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EPS - Example An all equity financed firm has $1 million in  assets and 10,000 shares of stock (stock price =  $100). Earnings before interest and taxes next  year will be either $50,000, $125,000, or  $200,000 depending on the economic conditions.  These earnings are expected to continue forever.  The payout ratio is 100%.  The firm is thinking about a leverage  recapitalization, selling $300,000 of debt and  using the proceeds to repurchase stock. The  interest rate is 10%.  How does this transaction effect the firm’s EPS,  ROE, and stock price? (IGNORE TAXES)
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Example  Current: All Equity firm Bad Bad Expected Expected Good Good # shares # shares 10,000 10,000 10,000 10,000 10,000 10,000 Debt Debt $0 $0 $0 $0 $0 $0 EBIT EBIT $50,000 $50,000 $125,000 $125,000 $200,000 $200,000 Interest Interest 0 0 0 Net Income Net Income $50,000 $50,000 $125,000 $125,000 $200,000 $200,000 EPS EPS $5 $5 $12.50 $12.50 $20 $20 In the Expected state: EPS = NI / # shares =  $12.50 Stock price  = $100 r E  = EPS / Price = NI / Common Equity     = 12.5%
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Example Recapitalize: 30% Debt Bad Bad Expected Expected Good Good # shares # shares 7,000 7,000 7,000 7,000 7,000 7,000 Debt Debt $300,000 $300,000 $300,000 $300,000 $300,000 $300,000 EBIT EBIT $50,000 $50,000 $125,000 $125,000 $200,000 $200,000 Interest Interest $30,000 $30,000 $30,000 $30,000 $30,000 $30,000 Net Income Net Income $20,000 $20,000 $95,000 $95,000 $170,000 $170,000 EPS EPS $2.86 $2.86
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This note was uploaded on 02/17/2012 for the course FIN 4414 taught by Professor Staff during the Spring '08 term at University of Florida.

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08Capital+Structure - CapitalStructure Fromlasttime...

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