Increase leverage by issuing debt and repurchasing outstanding shares o

Increase leverage by issuing debt and repurchasing

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Increase leverage by issuing debt and repurchasing outstanding shares o Decrease leverage by issuing new shares and retiring outstanding debt Cost of Capital o Value of firm is maximized when WACC is minimized. Example of Capital Restructuring Change from D/E Ratio of 0 to 1 Increase leverage by issuing debt and repurchase outstanding shares o No. of shares repurchased = $4,000,000 / $20 = 200,000 shares The Effect of Financial Leverage How does leverage affect the EPS and ROE of a firm? (Ignore the effect of taxes first) Increase amount of debt financing = Increase the fixed interest expense o Good Year: Pay fixed costs and have more left over for stockholders o Bad Year: Still have to pay fixed costs and have less left over for stockholders
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52 Variability in ROE o Current: ROE ranges from 6.25% to 18.75% o Proposed: ROE ranges from 2.50% to 27.50% Variability in EPS o Current: EPS ranges from $1.25 to $3.75 o Proposed: EPS ranges from $0.50 to $5.50 The variability in both ROE and EPS increases when financial leverage is increased. Shareholders are exposed to more risk with higher leverage. QUESTION: The Leverage has effect on expected return to shareholders. Does it mean that changing capital structure will change stock prices? No (in this case), because investors can use personal borrowing to alter the degree of financial leverage. So it makes no difference what capital structure that the firm is using. However, this is when we ignore taxes and transaction costs. The irrelevance of capital structure is only true under a simple world: no taxes and no bankruptcy cost. Example: Homemade Leverage Current Capital Structure Investor borrows $2000 at 10% and uses $2000 of her own to buy 200 shares of stock. (Replicates D/E Ratio proposed by company) Payoffs: No. of shares x EPS I/R (Debt) Recession: 200(1.25) - .1(2000) = $50 Expected: 200(2.50) - .1(2000) = $300 Expansion: 200(3.75) - .1(2000) = $550 Mirrors the payoffs from purchasing 100 shares from the firm under the proposed capital structure Proposed Capital Structure Investor buys $2000 worth of stock (100 shares) Payoffs: Recession: 100(.50) = $50 Expected: 100(3.00) = $300 Expansion: 100(5.50) = $550
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53 Capital Structure Theory Modigliani and Miller Theory of Capital Structure Proposition I: The Pie Model o Value of the firm is independent of the firm’s capital structure o Regardless of the D/E ratio, the fi rm’s value remains the same. Proposition II WACC, cost of capital o Firm’s cost of equity capital is a positive linear function of the firm’s capital structure o Let WACC = R A = (E/V) R E + (D/V) R D where V = E +D R E = R A + (R A R D ) x (D/E) o WACC does not depend on the D/E Ratio o Firm’s overall cost of capital is unaffected by its capital structure. Three Special Cases (Assumptions) Case I Case II Case III No corporate or personal taxes No bankruptcy costs Corporate taxes, but no personal taxes No bankruptcy costs Corporate taxes, but no personal taxes Bankruptcy costs Cash Flows, Risk of Cash Flows and Required Return Cash flow from assets (total cash flow) = Cash flow to creditors + Cash flow to shareholders o R A Risk of total cash flow o R D Risk of cash flow to creditors o R
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