Chapter 17 Leverage and Capital Structure 0
0 Chapter 17 Leverage and Capital Structure
Chapter Outline The Capital Structure Question The Effect of Financial Leverage Capital Structure and the Cost of Equity Corporate Taxes and Capital Structure Bankruptcy Costs Optimal Capital Structure Observed Capital Structures A Quick Look at the Bankruptcy Process
1 Chapter Outline n The Capital Structure Question n The Effect of Financial Leverage n Capital Structure and the Cost of Equity n Corporate Taxes and Capital Structure n Bankruptcy Costs n Optimal Capital Structure n Observed Capital Structures n A Quick Look at the Bankruptcy Process
Key Concepts and Skills Understand the effect of financial leverage on cash flows and cost of equity Understand the impact of taxes and bankruptcy on capital structure choice Understand the basic components of the bankruptcy process 2
2 Key Concepts and Skills n Understand the effect of financial leverage on cash flows and cost of equity n Understand the impact of taxes and bankruptcy on capital structure choice n Understand the basic components of the bankruptcy process
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 Increase leverage by issuing debt and repurchasing outstanding shares Decrease leverage by issuing new shares and retiring outstanding debt 3
3 Capital Restructuring n We are going to look at how changes in capital structure affect the value of the firm, all else equal n Capital restructuring involves changing the amount of leverage a firm has without changing the firm’s assets n Increase leverage by issuing debt and repurchasing outstanding shares n Decrease leverage by issuing new shares and retiring outstanding debt
Choosing a Capital Structure What is the primary goal of financial managers? Maximize stockholder wealth We want to choose the capital structure that will maximize stockholder wealth We can maximize stockholder wealth by maximizing firm value or minimizing WACC
4 Choosing a Capital Structure n What is the primary goal of financial managers? q Maximize stockholder wealth n We want to choose the capital structure that will maximize stockholder wealth n We can maximize stockholder wealth by maximizing firm value or minimizing WACC
The Effect of Leverage How does leverage affect the EPS and ROE of a firm? When we increase the amount of debt financing,we increase the fixed interest expense If we have a really good year,then we pay our fixed costs,and have more left over for our stockholders If we have a really bad year,we still have to pay our fixed costs,and have less left over for our stockholders Leverage amplifies the variation in both EPS and ROE 5
5 The Effect of Leverage n How does leverage affect the EPS and ROE of a firm? n When we increase the amount of debt financing, we increase the fixed interest expense n If we have a really good year, then we pay our fixed costs, and have more left over for our stockholders n If we have a really bad year, we still have to pay our fixed costs, and have less left over for our stockholders n Leverage amplifies the variation in both EPS and ROE
Example:Financial Leverage,EPS,and ROE-I We will ignore the effect of taxes at this stage What happens to EPS and ROE when we issue debt and buy back shares of stock? Fin ancial Leverage Ex ample 6
6 Example: Financial Leverage, EPS, and ROE - I n We will ignore the effect of taxes at this stage n What happens to EPS and ROE when we issue debt and buy back shares of stock?
Example:Financial Leverage,EPS,and ROE-II Variability in ROE Current:ROE ranges from 6.25%to 18.75% Proposed:ROE ranges from 2.50%to 27.50% Variability in EPS Current:EPS ranges from $1.25 to $3.75 Proposed:EPS ranges from $0.50 to $5.50 ■ The variability in both ROE and EPS increases when financial leverage is increased
7 Example: Financial Leverage, EPS, and ROE - II n Variability in ROE q Current: ROE ranges from 6.25% to 18.75% q Proposed: ROE ranges from 2.50% to 27.50% n Variability in EPS q Current: EPS ranges from $1.25 to $3.75 q Proposed: EPS ranges from $0.50 to $5.50 n The variability in both ROE and EPS increases when financial leverage is increased
Break-Even EBIT Find EBIT where EPS is the same under both the current and proposed capital structures 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 8
8 Break-Even EBIT n Find EBIT where EPS is the same under both the current and proposed capital structures n If we expect EBIT to be greater than the break- even point, then leverage is beneficial to our stockholders n If we expect EBIT to be less than the break-even point, then leverage is detrimental to our stockholders
Example:Break-Even EBI'T EBIT EBIT-400,000 400,000 200,000 EBIT EBT-0nam） EBIT=2EBIT -800000 EBIT=$800,000 800,000 EPS 二 $2.00 400,000 Break-even Graph 9
9 Example: Break-Even EBIT $2.00 400,000 800,000 EPS EBIT $800,000 EBIT 2EBIT 800,000 EBIT 400,000 200,000 400,000 EBIT 200,000 EBIT 400,000 400,000 EBIT
