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Fin Man Reviewer CH 14

This document discusses capital structure and leverage. It defines business risk as the risk inherent in a firm's operations without debt, and financial risk as additional risk from using debt. Operating leverage occurs from using fixed costs, which increases business risk. The optimal capital structure balances higher expected return on equity and earnings per share from leverage against increased risk. It can be found by minimizing the weighted average cost of capital or maximizing stock price. Both methods yield the same optimal capital structure.

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Kriz Genesis Burgos
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97 views2 pages

Fin Man Reviewer CH 14

This document discusses capital structure and leverage. It defines business risk as the risk inherent in a firm's operations without debt, and financial risk as additional risk from using debt. Operating leverage occurs from using fixed costs, which increases business risk. The optimal capital structure balances higher expected return on equity and earnings per share from leverage against increased risk. It can be found by minimizing the weighted average cost of capital or maximizing stock price. Both methods yield the same optimal capital structure.

Uploaded by

Kriz Genesis Burgos
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as PDF, TXT or read online on Scribd
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CHAPTER 14 - doesn’t vary with changes in capital

structure.
CAPITAL STRUCTURE AND LEVERAGE
EBIT(1 − T)
Business Risk ROIC =
Investor-supplied capital
- riskiness inherent in the firm’s operations if
($400,000)(0.6)
it uses no debt =
$2,000,000
- commonly used measure of business risk is = 12%
ROIC
Financial Leverage
Business Risk Determinants
- the use of debt and preferred stock
• Competition
Financial Risk
• Uncertainty about demand (sales)
- additional risk concentrated on common
• Uncertainty about output prices stockholders as a result of financial leverage
• Uncertainty about costs Business Risk vs. Financial Risk
• Product obsolescence Business risk
• Foreign risk exposure - depends on business factors such as
• Regulatory risk and legal exposure competition, product obsolescence, and
operating leverage
• Operating leverage
Financial risk
Operating leverage
- depends only on the types of securities
- The use of fixed costs rather than variable issued
costs.
- more debt, more financial risk
- If most costs are fixed, hence do not
decline when demand falls, then the firm - concentrates business risk on stockholders
has high operating leverage. Optimal Capital Structure
- More operating leverage leads to more - the capital structure (mix of debt,
business risk, for then a small sales decline preferred, and common equity) at which P0
causes a big profit decline is maximized.
- Use operating leverage to get higher ROIC, - Trades off higher E(ROE) and EPS against
but risk also increases higher risk. The tax-related benefits of
Return on Invested Capital (ROIC) leverage are exactly offset by the debt’s risk-
related costs.
- measures the after-tax return that the
company provides for all its investors.
Target Capital Structure Both methods yield the same results.
- mix of debt, preferred stock, and common Stock Price with Zero Growth
equity with which the firm intends to raise
capital. D1 EPS DPS
P̂0 = = =
Sequence of Events in a Recapitalization rs − g rs rs
1. Firm announces the recapitalization. • If all earnings are paid out as
2. New debt is issued. dividends, E(g) = 0.
3. Proceeds are used to repurchase • EPS = DPS.
stock. • To find the expected stock price (P0),
• The number of shares repurchased is we must find the appropriate rs at
equal to the amount of debt issued each of the debt levels discussed.
divided by price per share.

(EBIT − rdD)(1 − T)
EPS =
Shares outstanding
($400,000)
EBIT $400(0.6)
,000
TIE = = = = 20x
Int. Exp.80,$20,000
000
= $3.00
The Hamada Equation
- because the increased use of debt causes
both the costs of debt and equity to
increase, we need to estimate the new cost
of equity.
- attempts to quantify the increased cost of
equity due to financial leverage.
- uses the firm’s unlevered beta, which
represents the firm’s business risk as if it had
no debt.
bL = bU[1 + (1 – T)(D/E)]
Finding Optimal Capital Structure
The firm’s optimal capital structure can be
determined two ways:
1. Minimizes WACC.
2. Maximizes stock price.

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