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CHAPTER 16
Capital Structure Decisions:
The Basics
Impact of leverage on returns
Business versus financial risk
Capital structure theory
Perpetual cash flow example
Setting the optimal capital
structure in practice
Copyright © 2002 by Harcourt, Inc. All rights reserved.
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Firm U Firm L
No debt $10,000 of 12% debt
$20,000 in assets $20,000 in assets
40% tax rate 40% tax rate
Firm U Firm L
EBIT $3,000 $3,000
Interest 0 1,200
EBT $3,000 $1,800
Taxes (40%) 1 ,200 720
NI $1,800 $1,080
ROE 9.0% 10.8%
High risk
0 E(EBIT) EBIT
Note that business risk focuses on operating
income, so it ignores financing effects.
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(More...)
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EBITL EBITH
Business risk:
Uncertainty in future EBIT.
Depends on business factors such as
competition, operating leverage, etc.
Financial risk:
Additional business risk concentrated
on common stockholders when financial
leverage is used.
Depends on the amount of debt and
preferred stock financing.
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Firm U: Unleveraged
Economy
Bad Avg. Good
Prob. 0.25 0.50 0.25
EBIT $2,000 $3,000 $4,000
Interest 0 0 0
EBT $2,000 $3,000 $4,000
Taxes (40%) 800 1,200 1,600
NI $1,200 $1,800 $2,400
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Firm L: Leveraged
Economy
Bad Avg. Good
Prob.* 0.25 0.50 0.25
EBIT* $2,000 $3,000 $4,000
Interest 1,200 1,200 1,200
EBT $ 800 $1,800 $2,800
Taxes (40%) 320 720 1,120
NI $ 480 $1,080 $1,680
*Same as for Firm U.
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Firm U Bad Avg. Good
BEP 10.0% 15.0% 20.0%
ROI* 6.0% 9.0% 12.0%
ROE 6.0% 9.0% 12.0%
8
8
8
TIE
Firm L Bad Avg. Good
BEP 10.0% 15.0% 20.0%
ROI* 8.4% 11.4% 14.4%
ROE 4.8% 10.8% 16.8%
TIE 1.7x 2.5x 3.3x
*ROI = (NI + Interest)/Total financing.
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Profitability Measures:
U L
E(BEP) 15.0% 15.0%
E(ROI) 9.0% 11.4%
E(ROE) 9.0% 10.8%
Risk Measures:
σROE 2.12% 4.24%
CVROE 0.24 0.39
E(TIE) 8 2.5x
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Conclusions
Basic earning power = BEP =
EBIT/Total assets is unaffected by
financial leverage.
L has higher expected ROI and ROE
because of tax savings.
L has much wider ROE (and EPS)
swings because of fixed interest
charges. Its higher expected return
is accompanied by higher risk. (More...)
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MM theory
Zero taxes
Corporate taxes
Corporate and personal taxes
Trade-off theory
Signaling theory
Debt financing as a managerial
constraint
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Hamada’s Equation
Trade-off Theory
Signaling Theory
MM assumed that investors and
managers have the same information.
But, managers often have better
information. Thus, they would:
Sell stock if stock is overvalued.
Sell bonds if stock is undervalued.
Investors understand this, so view
new stock sales as a negative signal.
Implications for managers?
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Debt Financing As
a Managerial Constraint
Amount
Borrowed (000) kd
$ 0 -
250 10.0%
500 11.0
750 13.0
1,000 16.0
If company recapitalizes, debt would be
issued to repurchase stock.
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Sequence of Events in a
Recapitalization
Dividends/kS = (EBIT)(1-T)/kS
= 500,000 (1 - 0.40)/kS
Debt(000s) D/E bL kS
0 0 2.25 15.00%
250 0.142 2.44 15.77
500 0.333 2.70 16.80
750 0.600 3.06 18.24
1,000 1.000 3.60 20.40
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Shares $250
= = 12.15.
repurchased $20.57
Shares
= n1 = 100 - 12.15 = 87.85.
remaining
Debt(000s) kD Divs kS E
0 na 300 15.00% 2,000
250 10% 285 15.77 1,807
500 11% 267 16.80 1,589
750 13% 241.5 18.24 1,324
1,000 16% 204 20.40 1,000
(More...)
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