FIN301CHAPTER13(6)

FIN301CHAPTER13(6) - 1-1 13-1 Capital Structure/Financial...

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1-1 13-1 Capital Structure/Financial Leverage The capital structure goal for a Company is to establish that ratio of debt/equity that maximizes shareholder wealth by maximizing the value of the stock price Financial leverage refers to the degree to which a firm relies on debt relative to equity in its capital structure (the right side of balance sheet) in order to finance assets (the left side of balance sheet) Financial leverage can help a company or hurt a company: as we shall see 0
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1-2 13-2 Financial Leverage Considered We see in Table 13.2 that financial leverage—use of debt relative to equity— boosts EPS when business is strong (e.g. EBIT $1.5 million); but it reduces EPS when business is weak (e.g. EBIT $0.5 million) Bob: Work through levered and unlevered/all-equity EPS calculations when EBIT=$0.5 million & $1.5 million 2
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1-3 13-3 Notion of “Breakeven EBIT” An important consideration is “Breakeven EBIT”: the level of EBIT where Financial Leverage deployed doesn’t help and doesn’t hurt EPS In the Trans Am example from Table 13.2 data “Breakeven EBIT” = $800,000; Bob Show Calc Above Breakeven EBIT: EPS gets boosted by financial leverage; below Breakeven EBIT: EPS gets lowered by financial leverage Bob: Now work Example 13.1 & and Homework # 4 (just for Breakeven EBIT) 3
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1-4 13-4 M&M Proposition I No Taxes Put forward in 1958 by then-Carnegie colleagues Merton Miller & Franco Modigliani concept argues that because owners of a given stock can theoretically borrow or lend money on their own—through “Homemade Leverage”— to offset management’s Financial Leverage decisions … … the WACC/Ra and the value of the firm are unaffected by capital structure decisions (meaning D:E) Keep in mind this formula: Ra =(E/V) X Re + (D/V) X Rd 4
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1-5 13-5 M&M Proposition 1 No Taxes Homemade leverage has to do with an individual selling shares of stock and loaning out the proceeds or … … borrowing money and using that borrowed money in order to buy more stock Realize that a firm’s value/price is inversely determined by its WACC/Ra aka “the discount rate” that gets applied to the cash flows 5
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