Ch. 16 - Financial Leverage and Capital Structure
Chpt.16 Financial Leverage and Capital Structure
Financial Leverage
Chapter Outline
Financial Leverage Effect of leverage Break-even Analysis Homemade Leverage M&M Propositions (I & II): optimal D/E? No tax Corporate tax Corporate tax & bankruptcy costs Corporate & personal taxes Arbitrage
The Capital-Structure Question and The Pie Model
The value of a firm is defined to be the sum of the value of the firm’s debt and the firm’s equity. V=E+B If the goal of the management of the firm is to make the firm as valuable as possible, the the firm should pick the debt-equity ratio that makes the pie as big as possible.
S B
Value of the Firm
The Capital-Structure Question
There are really two important questions: 1. Why should the stockholders care about maximizing firm value? Perhaps they should be interested in strategies that maximize shareholder value. 2. What is the ratio of debt-to-equity that maximizes the shareholder’s value? As it turns out, changes in capital structure benefit the stockholders if and only if the value of the firm increases.
Financial Leverage: An Example
A proposed change in financial leverage
Current Asset Debt Equity D/E Ratio Share Price Shares Out. Interest Rate $8,000,000 $0 Proposed $8,000,000 $4,000,000
$20 n/a
$20 10%
Financial Leverage: An Example
Current capital structure: No debt (unlevered)
Recession Normal $1,000,000 Expansion $1,500,000
EBIT Interest Net Income EPS ROE
$500,000
Financial Leverage: An Example
Proposed capital structure: D/E = 1 (levered)
Recession Normal $1,000,000 Expansion $1,500,000
EBIT Interest Net Income EPS ROE
$500,000
The Effects of Financial Leverage
The effect of financial leverage depends on EBIT When EBIT is high, financial leverage raises EPS and ROE, and vice versa Variability in EPS and ROE is increased under financial leverage
EPS vs EBIT (with and without debt)
EPS
5 4
With Debt
3
No Debt
2
Advantage to debt
1
0 -1
Financial Leverage
Chapter Outline
Financial Leverage Effect of leverage Break-even Analysis Homemade Leverage M&M Propositions (I & II): optimal D/E? No tax Corporate tax Corporate tax & bankruptcy costs Corporate & personal taxes Arbitrage
The Capital-Structure Question and The Pie Model
The value of a firm is defined to be the sum of the value of the firm’s debt and the firm’s equity. V=E+B If the goal of the management of the firm is to make the firm as valuable as possible, the the firm should pick the debt-equity ratio that makes the pie as big as possible.
S B
Value of the Firm
The Capital-Structure Question
There are really two important questions: 1. Why should the stockholders care about maximizing firm value? Perhaps they should be interested in strategies that maximize shareholder value. 2. What is the ratio of debt-to-equity that maximizes the shareholder’s value? As it turns out, changes in capital structure benefit the stockholders if and only if the value of the firm increases.
Financial Leverage: An Example
A proposed change in financial leverage
Current Asset Debt Equity D/E Ratio Share Price Shares Out. Interest Rate $8,000,000 $0 Proposed $8,000,000 $4,000,000
$20 n/a
$20 10%
Financial Leverage: An Example
Current capital structure: No debt (unlevered)
Recession Normal $1,000,000 Expansion $1,500,000
EBIT Interest Net Income EPS ROE
$500,000
Financial Leverage: An Example
Proposed capital structure: D/E = 1 (levered)
Recession Normal $1,000,000 Expansion $1,500,000
EBIT Interest Net Income EPS ROE
$500,000
The Effects of Financial Leverage
The effect of financial leverage depends on EBIT When EBIT is high, financial leverage raises EPS and ROE, and vice versa Variability in EPS and ROE is increased under financial leverage
EPS vs EBIT (with and without debt)
EPS
5 4
With Debt
3
No Debt
2
Advantage to debt
1
0 -1