As mentioned earlier holding other factors constant

This preview shows page 39 - 42 out of 64 pages.

ratio is excessive, the EPS can actually go down and the volatility of EPS rises further. As mentioned earlier, holding other factors constant, the change in operating leverage may affect the expected EBIT (depending on how the probability is distributed among the economic conditions and how the revenue changes from one condition to another). Since EPS is derived from EBIT, the change in operating leverage may also affect the expected EPS. Also, the change in operating leverage affects the standard deviation of EBIT; likewise, since EPS is derived from EBIT, the change in operating leverage also affects the standard deviation of EPS. In other words, an increase (decrease) in operating leverage makes both EBIT and EPS more (less) volatile. If a firm increases both operating leverage and financial leverage, the EPS can become much more volatile than before. On the other hand, if a firm increases operating leverage and at the same time reduces financial leverage (or vice versa), the volatility of the EPS may stay the same.
4.The trade-off capital structure theory
Balance Sheet(Market Value)Value of assetsVUVUCommon equity(VS)Balance Sheet(Market Value)Debt: VDValue of assetsVLVLCommon equity: VSVU: The value of the firm when it is not levered, i.e., when it is all-equity.VL: The value of the firm when it is levered; that is, when it has debt in the capital structure.The objective of making financing decision is to find the optimal capital structure to maximize VLand thereby maximize VS.
present valueof expected financial distress costs¿righ¿¿¿present value ofexpected agency costs¿righ¿¿¿(¿) (¿)¿VL=VU+TD¿¿¿VL: The value of the firm when it is levered.VU: The value of the firm when it is not levered, i.e., when it is all-equity.T: Corporate tax rateD: Total market value of debtTD: The present value of all future tax savingsInterest payments are tax-deductible; that is, using debt creates tax savings in each period in the future. Mathematically, the present value of this savings stream is equal to TD. If the firm fails to make the interest payment and/or principal payment, the firm is in default. When the firm is near default or in default, it is in financial distress. If the default continues, eventually the firm goes bankrupt and debt-holders takeover the firm. In this case shareholdervalue drops to zero. Financial distress costs1)Direct financial distress costs if the firm enters bankruptcy procedures: court, legal, professional fees, among others. Holding other factors constant, a higher debt ratio increases the probability for the firm to enter financial distress and thus the probability for these costs to occur. 2)Indirect financial distress costs from business operations: customers go away for the fear of not getting after-sale services; suppliers demand cash payment instead of granting credits; employees and managers spend more time finding a job elsewhere; the firm may be forced to sell some assets at a large discount for liquidity needs, among others. These occurrences cause losses to the firm. Holding other factors constant, a higher debt ratio

  • Left Quote Icon

    Student Picture

  • Left Quote Icon

    Student Picture

  • Left Quote Icon

    Student Picture