Capital Restructuring 16.1
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Transcript of Capital Restructuring 16.1
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Capital Restructuring 16.1
• We are going to look at how changes in capital structure affect the value of the firm, all else being equal
• Capital restructuring involves changing the amount of leverage a firm has without changing the firm’s assets
• Increase leverage by issuing debt and repurchasing outstanding shares
• Decrease leverage by issuing new shares and retiring outstanding debt
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Choosing a Capital Structure
• What is the primary goal of financial managers?• Maximize stockholder wealth
• We want to choose the capital structure that will maximize stockholder wealth
• We can maximize stockholder wealth by maximizing firm value or minimizing WACC
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The Effect of Leverage 16.2
• How does leverage affect the EPS and ROE of a firm?• When we increase the amount of debt financing, we
increase the fixed interest expense• If we have a really good year, then we pay our fixed
cost and we have more left over for our stockholders• If we have a really bad year, we still have to pay our
fixed costs and we have less left over for our stockholders
• Leverage amplifies the variation in both EPS and ROE
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Example: Financial Leverage, EPS and ROE
• We will ignore the effect of taxes at this stage
• What happens to EPS and ROE when we issue debt and buy back shares of stock?
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Microsoft Office Excel Worksheet
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Example: Financial Leverage, EPS and ROE continued
• Variability in ROE• Current: ROE ranges from 6.25% to 18.75%• Proposed: ROE ranges from 2.50% to 27.50%
• Variability in EPS• Current: EPS ranges from $1.25 to $3.75• Proposed: EPS ranges from $0.50 to $5.50
• The variability in both ROE and EPS increases when financial leverage is increased
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Break-Even EBIT
• Find EBIT where EPS is the same under both the current and proposed capital structures
• If we expect EBIT to be greater than the break-even point, then leverage is beneficial to our stockholders
• If we expect EBIT to be less than the break-even point, then leverage is detrimental to our stockholders
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Example: Financial Leverage, EPS and ROE continued
$2.00400,000
800,000EPS
$800,000EBIT
800,0002EBITEBIT
400,000EBIT200,000
400,000EBIT
200,000
400,000EBIT
400,000
EBIT
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Microsoft Office Excel Worksheet
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Example: Homemade Leverage and ROE
• Current Capital Structure
• Investor borrows $2000 and uses $2000 of their own to buy 200 shares of stock
• Payoffs:• Recession: 200(1.25)
- .1(2000) = $50• Expected: 200(2.50)
- .1(2000) = $300• Expansion: 200(3.75)
- .1(2000) = $550
• Mirrors the payoffs from purchasing 100 shares from the firm under the proposed capital structure
• Proposed Capital Structure• Investor buys $1000 worth
of stock (50 shares) and $1000 worth of ABC bonds paying 10%.
• Payoffs:• Recession: 50(.50) + .1(1000)
= $125• Expected: 50(3.00) + .1(1000)
= $250• Expansion: 50(5.50)
+ .1(1000) = $375
• Mirrors the payoffs from purchasing 100 shares under the current capital structure
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