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Capital Structure
Financing decisions
The question wed like to address is, should
Capital Structure
Capital Structure
Capital Structure
costs.
If most costs are fixed, hence do not decline
when demand falls, then the firm has high
operating leverage. In other words, the
higher proportion of fixed costs, the higher is
the operating leverage.
Capital Structure
Capital Structure
increases.
What are the indicators?
ROE is more sensitive to the change in BEP.
Equity beta increases which lead to cost of
company valuation.
Capital Structure
Firm. A Firm B
Firm A
Firm B
Debt
500.0
200.0
500.0
200.0
Equity
500.0
800.0
500.0
800.0
Total Assets
1,000.0 1,000.0
1,000.0
1,000.0
BEP
0.20
Operating
Income
200.0
Interest Expense
(10%)
50.0
0.20
0.10
0.10
200.0
100.0
100.0
20.0
50.0
20.0
EBT
Capital Structure
180.0
50.0
80.0
150.0
negative?
Because the use of debt could create
Capital Structure
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Capital Structure
Capital Structure
Capital Structure
(1963).
MM theory based on assumptions that
capital market is perfect, and company
pays or does not pay corporate income
tax.
Perfect capital market means, among
other things, there is no bankruptcy
costs.
Trade-off theory takes into account
bankruptcy costs.
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Capital Structure
MM theory
Proposition
Market
condition
Perfect market
No tax
VL = VU
Perfect market
With tax
VL = VU + PV of tax
savings
(because interest
expense is tax
deductible)
Proposition I
(concerning
value of the
firm)
Capital Structure
Proposition II
(concerning cost
of equity)
rs = rsU + (D/S)(rsU
rd )
rs = rsU + (D/S)(rsU
rd) (1 t)
Capital Structure
theory.
Moderate debt column shows no financial
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stockholders.
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Capital Structure
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Capital Structure
Sales revenues
Fixed costs
Depreciation
Variable costs
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(1)
No
debt
(2)
Modera
te debt
(3)
High
debt
(4)
Very
high
debt
120.0
10.0
20.0
60.0
120.0
10.0
20.0
60.0
120.0
10.0
20.0
60.0
120.0
10.0
20.0
60.0
Operating income
Interest expense
30.0
-
30.0
10.0
30.0
12.5
30.0
18.0
30.0
9.0
20.0
6.0
17.50
5.25
12.0
3.6
21.0
14.0
12.25
8.4
Capital Structure
(3)
High
debt
(4)
Very
high
debt
0.15
140.0 m
0.167
84.0 m
0.204
60 m
0.28
30.0 m
Number of shares
Price per share, Rp.
100,000
1,400
51,220
1,640
37,500
1,600
20,000
1,500
0.125
80.0 m
0.125
100.0 m
0.15
120.0 m
140.0 m
164.0 m
160.0 m
150.0 m
0.15
0.128
0.131
0.14
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(1)
(2)
No debt Modera
te debt
Capital Structure
Capital Structure
(2)
Moder
ate
debt
(3)
High
debt
(4)
Very
high
debt
0.15
140.0 m
0.167
84.0 m
0.204
60.0 m
0.28
30.0 m
Number of shares
Price per share, Rp.
100,000
1,400
49,911
1,683
37,430
1,603
21,390
1,403
0.125
80.0 m
0.125
100.0 m
0.15
120.0 m
140.0 m
164.0 m
160.0 m
150.0 m
0.15
0.128
0.131
0.14
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(1)
No
debt
Capital Structure
(1)
No
debt
(2)
Moder
ate
debt
(3)
High
debt
150.0 m
150.0 m
150.0 m
150.0 m
80.0 m
100.0 m
120.0 m
150.0 m
70.0 m
50.0 m
30.0 m
0.14
0.20
0.245
0.28
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Capital Structure
(4)
Very
high
debt
Conclusions
Optimal capital structure is at moderate
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Capital Structure
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A further note
(contd)
....
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Capital Structure