CLASS_04 - FINA 463 February 7 2012 Josh Pierce M&M 2 M&M 3...

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FINA 463 February 7, 2012 Josh Pierce
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2 M&M
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3 M&M
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4 The effect of leverage Financial leverage is the extent to which a firm relies on debt in its operations ROE = Net Income / Outstanding Equity EPS = Net Income / Shares Outstanding Higher debt means greater fixed interest expenses If firm has a good year: it pays fixed interest and has more left for shareholders If firm has a bad year: it still has to pay fixed interest and less is left for shareholders Idea is that leverage amplifies the variation in the payoffs for shareholders, hence in EPS & ROE
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5 An example of leverage What happens to EPS & ROE when a firm issues debt and buys back shares of stock with proceeds? We ignore the effect of taxes at this stage Current Proposed Assets $5,000,000 $5,000,000 Debt 0 2,500,000 Equity 5,000,000 2,500,000 D/E ratio 0 1 Share price (assume it doesnÕ t change when shares are repurchased) $10 $10 Shares outstanding 500,000 250,000 Interest Rate N/A 10% We start with an all-equity firm Now the firm has fixed obligations
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6 An example of leverage Current: all-equity firm Proposed: leveraged firm (D/E ratio = 1) Recession Expected Expansion EBIT $300,000 $650,000 $800,000 Interest Expense 0 0 0 Net Income $300,000 $650,000 $800,000 ROE 6% 13% 16% EPS $0.60 $1.30 $1.60 Leverage increases the variability of shareholders’ payoffs Greater variability in ROE Recession Expected Expansion EBIT $300,000 $650,000 $800,000 Interest Expense 250,000 250,000 250,000 Net Income $50,000 $400,000 $550,000 ROE 2% 16% 22% EPS $0.20 $1.60 $2.20 NI / $5 million = NI / 500,000 = NI / $2.5 million = NI / 250,000 = Greater variability in EPS Fixed interest expenses regardless of economy
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7 Break-Even EBIT Break-Even EBIT : EBIT where EPS is the same under both current and proposed capital structures If we expect EBIT to be greater than break-even, then leverage is beneficial to stockholders: EPS ↑ If we expect EBIT to be less than break-even, then leverage is detrimental to stockholders: EPS ↓ Net Income = EBIT – Interest Expenses EPS = Net Income / Shares Outstanding BE EBIT such that EPS CURRENT = EPS PROPOSED EBIT / 500,000 = (EBIT – 250,000) / 250,000 Break-Even EBIT = $500,000
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8 Capital Structure Theory If there is nothing special about corporate borrowing, why should capital structure be relevant? Franco Modigliani & Merton Miller made the following, famous argument The value of the firm is determined by the cash flow to the firm and the risk of its assets Only changes in the cash flows or in the risk of the cash flows should then affect firm value Therefore, capital structure is irrelevant M&M won each a Nobel Prize for their insights into the financing decisions of the firm
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9 Capital Structure Theory … more precisely The value of the firm is NOT affected by changes in the capital structure The cash flows of the firm do not change,
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This note was uploaded on 02/17/2012 for the course FINA 463 taught by Professor Tsyplakov during the Spring '10 term at South Carolina.

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CLASS_04 - FINA 463 February 7 2012 Josh Pierce M&M 2 M&M 3...

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