Capital Structure Theory & Practice (Leverage)

Capital Structure Theory & Practice (Leverage) -...

Info iconThis preview shows pages 1–12. Sign up to view the full content.

View Full Document Right Arrow Icon
1 CAPITAL STRUCTURE CAPITAL STRUCTURE AND LEVERAGE AND LEVERAGE Stony Brook College of Business BUS 330 V. Giardini
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 CAPITAL STRUCTURE CAPITAL STRUCTURE The mix of debt and equity within a firm's capital (Consider preferred stock a form of debt) The use of debt is Financial Leverage Financial Leverage THE CENTRAL ISSUE THE CENTRAL ISSUE Can the use of leverage affect the value of a firm's equity or its stock price? RISK IN THE CONTEXT OF LEVERAGE RISK IN THE CONTEXT OF LEVERAGE Define risk as variation in recorded financial performance measured at ROE and EPS
Background image of page 2
3 PERFORMANCE MEASURES PERFORMANCE MEASURES ROE = EAT Equity and EPS = EAT # shares
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 Variation in Recorded Financial Performance Variation in Recorded Financial Performance Arises from Two Sources Arises from Two Sources Variation in Business Operations The Use of Debt in the Capital Structure (Leverage) BUSINESS RISK BUSINESS RISK Variation in operating performance measured at EBIT FINANCIAL RISK FINANCIAL RISK The additional variation in ROE and EPS (over that in EBIT) caused by the use of Financial Leverage
Background image of page 4
5 Sources of Variation Performance Variations as Ris k Variation in Business Business Operations Operations Create Variation EBIT in EBIT Business Risk Plus Additional Variation from Financial Risk Financing the Effects of debt Financing Leads to Overall Performance Variation in Risk in Measured by ROE and EPS Financial ROE and EPS Performance Figure: Business and Financial Risk
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 THE GOOD NEWS THE GOOD NEWS CONSIDER THE EFFECT OF INCREASING LEVERAGE WHEN BUSINESS IS GOOD GOOD
Background image of page 6
7 Leverage Analysis - Business is Good! Arizona Hot Air Balloon Corporation ($000) Leverage Scenarios #1 #2 #3 0% Debt 50% Debt 80% Debt Capital Debt - $ 500 $ 800 Equity $ 1,000 500 200 Total $ 1,000 $ 1,000 $ 1,000 Shares @ $10 100,000 50,000 20,000 Rev $ 1,000 $ 1,000 $ 1,000 Cost/Exp 800 800 800 EBIT $ 200 $ 200 $ 200 Interest (10%) - 50 80 EBT $ 200 $ 150 $ 120 Tax (40%) 80 60 48 EAT $ 120 $ 90 $ 72 ROE 12% 18% 36% EPS $1.20 $1.80 $3.60
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 WHEN DOES LEVERAGE HELP? WHEN DOES LEVERAGE HELP? The Return on Capital vs. the Cost of Debt LEVERAGE HELPS IF: ROCE > After Tax Cost of Debt ROCE = EBIT(1- T) Debt Equity +
Background image of page 8
9 But Leverage Works Both Ways THE BAD NEWS THE BAD NEWS CONSIDER THE EFFECT OF INCREASING LEVERAGE WHEN BUSINESS IS POOR POOR
Background image of page 9

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

View Full DocumentRight Arrow Icon
10 Leverage Analysis - Business is Bad!! Arizona Hot Air Balloon Corporation ($000) Leverage Scenarios #1 #2 #3 0% Debt 50% Debt 80% Debt Capital Debt - $ 500 $ 800 Equity $ 1,000 500 200 Total $ 1,000 $ 1,000 $ 1,000 Shares @ $10 100,000 50,000 20,000 Rev $ 800 $ 800 $ 800 Cost/Exp 720 720 720 EBIT $ 80 $ 80 $ 80 Interest (10%) - 50 80 EBT $ 80 $ 30 $ - Tax (40%) 32 12 - EAT $ 48 $ 18 $ - ROE 4.8% 1.8% 0% EPS $0.48 $0.18 $0.00
Background image of page 10
11 FINANCIAL LEVERAGE AND FINANCIAL LEVERAGE AND FINANCIAL RISK FINANCIAL RISK Financial leverage Multiplies good good results into great results Multiplies bad bad results into terrible results ROE and EPS make wider swings with more leverage The incremental variation is financial risk
Background image of page 11

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

View Full DocumentRight Arrow Icon
Image of page 12
This is the end of the preview. Sign up to access the rest of the document.

Page1 / 36

Capital Structure Theory & Practice (Leverage) -...

This preview shows document pages 1 - 12. Sign up to view the full document.

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