Capital_Structure_Winter_2010

Capital_Structure_Winter_2010 - BusM 401 Capital Structure...

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BusM 401 Capital Structure
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2 Leverage Operating leverage: the commitment to fixed production costs Financial leverage: the commitment to fixed financing costs In general, leverage increases owners’ expected return and risk Does financial leverage increase ROE? Yes, as long as the earnings on the borrowed money exceed interest payments on the borrowed money.
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3 Evaluating the risk-return tradeoff with increased leverage Ratio analysis Compare different financing scenarios Compare to similar firms in the industry Pro forma financial statements Sensitivity analysis Ask “what-if” questions Evaluate the impact on earnings
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4 Example - River Cruises - All Equity Financed 17.5% 12.5% 7.5% shares on Return 1.75 1.25 $.75 EPS 175,000 125,000 $75,000 EBIT Boom Expected Bust Economy the of State Outcome million 1 $ Shares of Value Market $10 share per Price 100,000 shares of Number Data (Source: Brealey, Myers, and Marcus, (Source: Brealey, Myers, and Marcus, Fundamentals of Corporate Finance Fundamentals of Corporate Finance )
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5 Example cont. 50% debt 25% 15% 5% shares on Return 2.50 1.50 $.50 EPS 125,000 75,000 $25,000 earnings Equity 50,000 50,000 $50,000 Interest 175,000 125,000 $75,000 EBIT Boom Expected Bust Economy the of State Outcome 500,000 $ debt of ue Market val 500,000 $ Shares of Value Market $10 share per Price 50,000 shares of Number Data
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6 Range of earnings chart River Cruises $0.00 $0.50 $1.00 $1.50 $2.00 $2.50 $3.00 $0 $50,000 $100,000 $150,000 $200,000 EBIT EPS All Equity 50% Debt Bust Expected Boom
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7 A long-term financing strategy Ratio analysis, pro formas, and range of earnings charts give important information about risk/return tradeoffs But managers should also have an idea for generally what level of debt the company should carry The optimal amount of debt depends on a number of other factors
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8 The level of debt is irrelevant INTUITION #1 Value is created from real assets, not financial assets. Capital structure only matters if it affects the firm’s cash flows. INTUITION #2 Individual investors can replicate the debt position of the company, so there is no value in the firm taking on debt. (Note: Assumptions of the irrelevance proposition include no taxes, no bankruptcy costs, equal information between the firm and investors, and no effects on incentives.)
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9 Example - River Cruises - All Equity Financed - Debt replicated by investors - (borrow $10 to buy an extra share) 25% 15% 5% investment $10 on Return 2.50 1.50 $.50 investment on earnings Net 1.00 1.00 $1.00 10% @ Interest : LESS 3.50 2.50 $1.50 shares two on Earnings Boom Expected Bust Economy the of State Outcome M&M (Debt Policy Doesn’t Matter)
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10 MM is not a literal statement about the real world. It obviously leaves important things out. But it gets you to ask the right question: How is this financing
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Capital_Structure_Winter_2010 - BusM 401 Capital Structure...

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