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Corporte Finace Essay

3441 words - 14 pages

Financial Leverage And Capital Structure Policy

Chapter Outline

     

The Capital Structure Question The Effect of Financial Leverage Capital Structure and the Cost of Equity Capital M&M Propositions I and II with Corporate Taxes Bankruptcy Costs Optimal Capital Structure


Capital Restructuring

We are going to look at how changes in capital structure affect the value of the firm, all else


Capital restructuring involves changing the amount of leverage a firm has without changing the firm’s assets  The firm can increase leverage by issuing debt and repurchasing outstanding shares  The firm can decrease leverage by issuing new shares and ...view middle of the document...


Financial Leverage, EPS and ROE

Assets  Debt Equity D/E ratio Share price (assume it doesn’t change when shares are repurchased) Shares outstanding Interest Rate

Current 0 5,000,000 0 $10 500,000 N/A

Proposed 2,500,000 2,500,000 1 $10 250,000 10%

$5,000,000 $5,000,000

EBIT, ROE, and EPS in current capital structure: no Debt
Recession Expected EBIT Interest Expense Net Income ROA ROE Number of shares EPS 6% 6% 500,000 $0.60 $300,000 0 $300,000 13% 13% 500,000 $1.30 $650,000 0 $650,000 20% 20% 500,000 $2.00

Expansion $1,000,000 0 $1,000,000

Proposed capital structure: D/E = 1; interest rate = 10%
Recession EBIT Interest Expense Net Income ROA ROE
Number of shares

Expected $650,000 250,000 $400,000 8% 16% 250,000 $1.60

Expansion $1,000,000 250,000 $750,000 15% 30% 250,000 $3.00

$300,000 250,000 $50,000 1% 2% 250,000 $0.20

Financial Leverage Example


Example: Financial Leverage, EPS and ROE – Part II

Variability in ROE
 

Current: ROE ranges from 6% to 20% Proposed: ROE ranges from 2% to 30% Current: EPS ranges from $0.60 to $2.00 Proposed: EPS ranges from $0.20 to $3.00

Variability in EPS
 

The variability in both ROE and EPS increases when financial leverage is increased


Break-Even EBIT

$3.50 $3.00 $2.50 $2.00 $1.50 $1.00 $0.50 $0.00


Find EBIT where EPS is the same under both the current and proposed capital structures Financial Leverage: EPS and EBIT

Break-even Point: EPS = $1; EBIT = $500,000




$1,000,000 EBIT 10

What is EBIT at which EPS are the same under both capital structures

Example: Break-Even EBIT
EBIT  500,000 EBIT  500,000  500,000    250,000  2EBIT   $500,000 500,000  500,000  EPS EBIT


 250,000 250,000


 250,000 250,000  250,000

   EBIT  500,000  $1.00


Effect of leverage depends on the current level of EBIT
 If

we expect EBIT to be greater than the break-even point, then leverage is beneficial to our stockholders  If we expect EBIT to be less than the break-even point, then leverage is detrimental to our stockholders  At Breakeven point no effect of leverage

In General


 breakeven  iD



L U bep
N 


at N  EBIT






U bep
 E



P  iD


   effect effect

  D ( EBIT / E   E

bep L

bep bep bep
the the

iD ) ( D

iD  E


D ) / E


) / E

i ( D i of of

leverage leverage

is is

positive negative

The effect of financial leverage
 We

can conclude that:

The effect of financial leverage depends on EBIT Financial leverage increases ROE and EPS when EBIT is greater than the...

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