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Chapter 14
Establishing a Target Capital
Structure
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Capital Structure
Current Assets
Fixed Assets
Long Term Liabilities
Short Term Liabilities
Balance Sheet
Owner’s Equity
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Modigliani and Miller’s Proposition I
In the absence of taxes, transaction costsand other market imperfections, the value of firm is independent of its capital structure.
In equilibrium, identical assets must sell for identical prices, regardless of the manner inwhich the assets are financed.
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Modigliani and Miller’s Proposition I
Suppose two firms are identical in allrespects except for capital structure.
Firm U is unlevered, and Firm L has $1million in 10 percent debt.
Both firms have total assets of $ 3,5 millionand expected EBIT of $500,000.
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Modigliani and Miller’s Proposition I
Suppose the two firms have the following valuations:
Firm U Firm L
EBIT $500,000 $500,000
Interest 0 100,000
Dividends $500,000 $400,000
Cost of Equity 0.1429 0.16
Market Value of Equity $3,500,000 $2,500,000
Market Value of Debt 0 1,000,000
Market Value of Firm $3,500,000 $3,500,000
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Modigliani and Miller’s Proposition II
The cost of equity capital for a levered firmequals the overall cost of capital plus a riskpremium that equals the spread between theoverall cost of capital and the cost of debt.
E Dk k k k d e
/)( 00 −Where:
ke = Cost of Equity Capital
k0 = Weighted Average Cost of Capital
kd = Cost of Debt capital
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The MM’s Proposition II -A Graphical Representation
Debt / Equity
R
equir
edreturn
(k0 )
(ke )
(kd )
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Effects of Financial Leverage on ROE
25 100 CapitalStructure
ROA = 10
i = 8
D e b t
E q ui t y
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Effects of Financial Leverage on ROE
25 100 CapitalStructure
ROE = 16
ROA = 10
i = 8
D e b t
E q ui t y
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Effects of Financial Leverage on ROE
E Dir r ROE A A
/)( −+=
Where:
r A = return on assets before financing costs
i = after-tax cost of debt
D = amount of debt in the capital structure
E = amount of equity in the capital structure
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Consequences of Leverage
Hi-Tech Running Shoes needs $5 million inassets to support sales.
Option A: Issue 500,000 shares @ $10/share
Option B: Issue 250,000 shares @ $10/share;$2.5 million in debt @ 10%
Expected EBIT = $1,000,000;
EBIT (Low Estimate) = $ 200,000;
EBIT (High Estimate)= $ 2,000,000
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Consequences of Leverage
Effect of leverage on Hi-Tech’s Earnings Per Share
No Leverage 500,000 shares @ $ 10/share
States of the World
Bad Mediocre Normal Good
EBIT $200,000 $500,000 $1,000,000 $2,000,000
Less: Interest@ 10% 0 0 0 0
Equity Income $200,000 $500,000 $1,000,000 $2,000,000
Less: Tax @ 50% 100,000 250,000 500,000 1,000,000
Equity income after tax $100,000 $250,000 500,000 $1,000,000
EPS $.20 $.50 $1.00 $2.00
ROE (%) 2 5 10 20
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Consequences of Leverage
Effect of leverage on Hi-Tech’s Earnings Per Share
50 percent debt 250,000 shares @ $ 10/share; $2.5 million in debt @10%
States of the World
Bad Mediocre Normal Good
EBIT $200,000 $500,000 $1,000,000 $2,000,000
Less: Interest@ 10% 250,000 250,000 250,000 250,000Equity Income ($50,000) $250,000 $750,000 $1,750,000
Less: Tax @ 50% ($25,000) 125,000 375,000 875,000
Equity income after tax ($25,000) $125,000 $375,000 $875,000
EPS ($.10) $.50 $1.50 $3.50
ROE (%) -1 5 15 35
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Consequences of Leverage
EBIT-EPS Relationship anFinancial leverage
-2
-1
0
1
2
3
4
-200 300 800 1300 1800
EBIT (Thousands $)
E P S ( $ )
No debt50% Debt
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Consequences of Leverage
ROA-ROE Relationship anFinancial leverage
-10
0
10
20
30
-0.02 0.08 0.18
ROA
R O E No debt
50% Debt
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EBIT - EPS Indifference Point
B
Bc B
A
Ac A
N
P t I EBIT
N
P t I EBIT ])1)([(])1)([( **−−−
=
−−−
Where:
EBIT* = EBIT-EPS indifference point
IA,IB = interest expense under plan A and B
PA,PB = preferred stock dividends under plan A and B
tc = corporate tax rate
NA,NB = number of shares outstanding under plan A and B
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Hi-Tech’s EBIT - EPS IndifferencePoint
000,500$EBIT
000,250
)]50.0)(000,250EBIT[(
000,500
)]50.0)(0EBIT[(
Debt Stock
*
**
=
−
=
−