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Corporte Finace Essay

3441 words - 14 pages

Financial Leverage And Capital Structure Policy
0

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

1

Capital Restructuring

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

equal

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...


5

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%
6

$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
7

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
8

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

Financial Leverage Example

EPS

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

9

Break-Even EBIT

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

EPS

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

C…

$300,000

$650,000

$1,000,000 EBIT 10

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

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

EBIT

 250,000 250,000

U

 250,000 250,000  250,000

   EBIT  500,000  $1.00

11

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
12

In General
ROA EPS  EBIT A EPS EBIT N EBIT  EBIT      if if ROA ROA
U U

ROE

 breakeven  iD

EBIT E

U

L U bep
N 

at

at N  EBIT

EBIT

L

EBIT

bep
N

iD

U bep
 E

P

L
E

P  iD

D EBIT EBIT EBIT ROA  i  i 

L
   effect effect

  D ( EBIT / E   E

bep L

bep
bep bep bep
the the

bep
iD ) ( D

iD  E

)(

D ) / E

E

) / E

i ( D i of of

leverage leverage

is is

positive negative
13

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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