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Lecture Fundamentals of corporate finance - Chapter 16: Financial leverage and capital structure policy

After studying this chapter in the lecture, you should be able to: Explain how financial leverage affects earnings per share (EPS) and return on equity (ROE), compute the degree of financial leverage, define and compute the indifference earnings before interest and taxes (EBIT) and explain its importance in selecting between alternative financing opportunities, define and explain the term homemade leverage, explain why determining the optimal capital structure is important,. | T16.1 Chapter Outline Chapter 16 Financial Leverage and Capital Structure Policy Chapter Organization 16.1 The Capital Structure Question 16.2 The Effect of Financial Leverage 16.3 Capital Structure and the Cost of Equity Capital 16.4 M&M Propositions I and II with Corporate Taxes 16.5 Bankruptcy Costs 16.6 Optimal Capital Structure 16.7 The Pie Again 16.8 Observed Capital Structures 16.9 Long-term Financing under Financial Distress and Bankruptcy 16.10 Summary and Conclusions CLICK MOUSE OR HIT SPACEBAR TO ADVANCE copyright © 2002 McGraw-Hill Ryerson, Ltd. T16.2 Capital Structure, Cost of Capital, and the Value of the Firm Key issues: What is the relationship between capital structure and firm value? Measuring Capital Structure - Leverage and the Debt/Equity ratio What is the optimal capital structure? Preliminaries: Capital restructurings Optimal capital structure: firm value vs. stock value Optimal capital structure: firm value vs. WACC T16.3 Example: Computing Break-Even EBIT Ignoring taxes: A. With no debt: EPS = EBIT/500,000 B. With $2,500,000 in debt at 10%: EPS = (EBIT - $)/250,000 C. These are equal when: EPSBE = EBITBE/ = (EBITBE - $250,000)/250,000 D. With a little algebra: EBITBE = $500,000 So EPSBE = $ /share T16.3 Example: Computing Break-Even EBIT Ignoring taxes: A. With no debt: EPS = EBIT/500,000 B. With $2,500,000 in debt at 10%: EPS = (EBIT - $250,000)/250,000 C. These are equal when: EPSBE = EBITBE/500,000 = (EBITBE - $250,000)/250,000 D. With a little algebra: EBITBE = $500,000 So EPSBE = $1.00/share T16.4 Financial Leverage, EPS and EBIT EBIT ($ millions, no taxes) EPS ($) 0 0.2 0.4 0.6 0.8 1 3 2.5 2 1.5 1 0.5 0 – 0.5 – 1 D/E = 1 D/E = 0 T16.5 Degree of Financial Leverage The Degree of Financial Leverage is measured as Percentage Change in EPS Percentage Change in EBIT A convenient alternative calculation is Percentage Change in EPS Percentage Change in EBIT T16.6 EPS Versus EBIT (with and without debt) -3 -2 -1 0 1 2 3 4 5 - . | T16.1 Chapter Outline Chapter 16 Financial Leverage and Capital Structure Policy Chapter Organization 16.1 The Capital Structure Question 16.2 The Effect of Financial Leverage 16.3 Capital Structure and the Cost of Equity Capital 16.4 M&M Propositions I and II with Corporate Taxes 16.5 Bankruptcy Costs 16.6 Optimal Capital Structure 16.7 The Pie Again 16.8 Observed Capital Structures 16.9 Long-term Financing under Financial Distress and Bankruptcy 16.10 Summary and Conclusions CLICK MOUSE OR HIT SPACEBAR TO ADVANCE copyright © 2002 McGraw-Hill Ryerson, Ltd. T16.2 Capital Structure, Cost of Capital, and the Value of the Firm Key issues: What is the relationship between capital structure and firm value? Measuring Capital Structure - Leverage and the Debt/Equity ratio What is the optimal capital structure? Preliminaries: Capital restructurings Optimal capital structure: firm value vs. stock value Optimal capital structure: firm value vs. WACC T16.3 Example: Computing Break-Even EBIT .