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1、Leverage and Capital StructureChapter 1313.1Key Concepts and SkillsnUnderstand the effect of financial leverage on cash flows and cost of equitynUnderstand the impact of taxes and bankruptcy on capital structure choicenUnderstand the basic components of the bankruptcy process13.2Chapter OutlinenThe
2、Capital Structure QuestionnThe Effect of Financial LeveragenCapital Structure and the Cost of Equity CapitalnCorporate Taxes and Capital StructurenBankruptcy CostsnOptimal Capital StructurenObserved Capital StructuresnA Quick Look at the Bankruptcy Process13.3Capital RestructuringnWe are going to lo
3、ok at how changes in capital structure affect the value of the firm,all else equalnCapital restructuring involves changing the amount of leverage a firm has without changing the firms assetsnIncrease leverage by issuing debt and repurchasing outstanding sharesnDecrease leverage by issuing new shares
4、 and retiring outstanding debt13.4Choosing a Capital StructurenWhat is the primary goal of financial managers?nMaximize stockholder wealthnWe want to choose the capital structure that will maximize stockholder wealthnWe can maximize stockholder wealth by maximizing firm value or minimizing WACC13.5T
5、he Effect of LeveragenHow does leverage affect the EPS and ROE of a firm?nWhen we increase the amount of debt financing,we increase the fixed interest expensenIf we have a really good year,then we pay our fixed cost and we have more left over for our stockholdersnIf we have a really bad year,we stil
6、l have to pay our fixed costs and we have less left over for our stockholdersnLeverage amplifies the variation in both EPS and ROE13.6Example:Financial Leverage,EPS and ROEnWe will ignore the effect of taxes at this stagenWhat happens to EPS and ROE when we issue debt and buy back shares of stock?13
7、.7Example:Financial Leverage,EPS and ROEnVariability in ROEnCurrent:ROE ranges from 6.25%to 18.75%nProposed:ROE ranges from 2.50%to 27.50%nVariability in EPSnCurrent:EPS ranges from$1.25 to$3.75nProposed:EPS ranges from$0.50 to$5.50nThe variability in both ROE and EPS increases when financial levera
8、ge is increased13.8Break-Even EBITnFind EBIT where EPS is the same under both the current and proposed capital structuresnIf we expect EBIT to be greater than the break-even point,then leverage is beneficial to our stockholdersnIf we expect EBIT to be less than the break-even point,then leverage is
9、detrimental to our stockholders13.9Example:Break-Even EBIT$2.00400,000800,000EPS$800,000EBIT800,0002EBITEBIT400,000EBIT200,000400,000EBIT200,000400,000EBIT400,000EBIT13.10Example:Homemade Leverage and ROEnCurrent Capital StructurenInvestor borrows$2000 and uses$2000 of their own to buy 200 shares of
10、 stocknPayoffs:nRecession:200(1.25)-.1(2000)=$50nExpected:200(2.50)-.1(2000)=$300nExpansion:200(3.75)-.1(2000)=$550nMirrors the payoffs from purchasing 100 shares from the firm under the proposed capital structurenProposed Capital StructurenInvestor buys$1000 worth of stock(50 shares)and$1000 worth
11、of Trans Am bonds paying 10%.nPayoffs:nRecession:50(.50)+.1(1000)=$125nExpected:50(3.00)+.1(1000)=$250nExpansion:50(5.50)+.1(1000)=$375nMirrors the payoffs from purchasing 100 shares under the current capital structure13.11Capital Structure TheorynModigliani and Miller Theory of Capital StructurenPr
12、oposition I firm valuenProposition II WACCnThe value of the firm is determined by the cash flows to the firm and the risk of the assetsnChanging firm valuenChange the risk of the cash flowsnChange the cash flows13.12Capital Structure Theory Under Three Special CasesnCase I AssumptionsnNo corporate o
13、r personal taxesnNo bankruptcy costsnCase II AssumptionsnCorporate taxes,but no personal taxesnNo bankruptcy costsnCase III AssumptionsnCorporate taxes,but no personal taxesnBankruptcy costs13.13Case I Propositions I and IInProposition InThe value of the firm is NOT affected by changes in the capita
14、l structurenThe cash flows of the firm do not change,therefore value doesnt changenProposition IInThe WACC of the firm is NOT affected by capital structure13.14Case I-EquationsnWACC=RA=(E/V)RE+(D/V)RDnRE=RA+(RA RD)(D/E)nRA is the“cost”of the firms business risk,i.e.,the risk of the firms assetsn(RA
15、RD)(D/E)is the“cost”of the firms financial risk,i.e.,the additional return required by stockholders to compensate for the risk of leverage13.15Case I-ExamplenDatanRequired return on assets=16%,cost of debt=10%;percent of debt=45%nWhat is the cost of equity?nRE=.16+(.16-.10)(.45/.55)=.2091=20.91%nSup
16、pose instead that the cost of equity is 25%,what is the debt-to-equity ratio?n.25=.16+(.16-.10)(D/E)nD/E=(.25-.16)/(.16-.10)=1.5nBased on this information,what is the percent of equity in the firm?nE/V=1/2.5=40%13.16Figure 13.313.17The CAPM,the SML and Proposition IInHow does financial leverage affect systematic risk?nCAPM:RA=Rf+A(RM Rf)nWhere A is the firms asset beta and measures the systematic risk of the firms assetsnProposition IInReplace RA with the CAPM and assume that the debt is riskles
