CapitalStructureBasicConcepts.pptVIP

Chapter Outline 15.1 The Capital-Structure Question and The Pie Theory 15.2 Maximizing Firm Value versus Maximizing Stockholder Interests 15.3 Financial Leverage and Firm Value: An Example 15.4 Modigliani and Miller: Proposition II (No Taxes) 15.5 Taxes 15.6 Summary and Conclusions The Capital-Structure Question and The Pie Theory The value of a firm is defined to be the sum of the value of the firm’s debt and the firm’s equity. V = B + S The Capital-Structure Question There are really two important questions: Why should the stockholders care about maximizing firm value? Perhaps they should be interested in strategies that maximize shareholder value. What is the ratio of debt-to-equity that maximizes the shareholder’s value? As it turns out, changes in capital structure benefit the stockholders if and only if the value of the firm increases. Financial Leverage, EPS, and ROE Current Assets $20,000 Debt $0 Equity $20,000 Debt/Equity ratio 0.00 Interest rate n/a Shares outstanding 400 Share price $50 EPS and ROE Under Current Capital Structure Recession Expected Expansion EBIT $1,000 $2,000 $3,000 Interest 0 0 0 Net income $1,000 $2,000 $3,000 EPS $2.50 $5.00 $7.50 ROA 5% 10% 15% ROE 5% 10% 15% Current Shares Outstanding = 400 shares EPS and ROE Under Proposed Capital Structure Recession Expected Expansion EBIT $1,000 $2,000 $3,000 Interest 640 640 640 Net income $360 $1,360 $2,360 EPS $1.50 $5.67 $9.83 ROA 5% 10% 15% ROE 3% 11% 20% Proposed Shares Outstanding = 240 shares EPS and ROE Under Both Capital Structures Levered Recession Expected Expansion EBIT $1,000 $2,000 $3,000 Interest 640 640 640 Net income $360 $1,360 $2,360 EPS $1.50 $5.67 $9.83 ROA 5% 10% 15% ROE 3% 11% 20% Proposed Shares Outstanding = 240 shares Financial Leverage and EPS Assumptions of the Modigliani-Miller Model Homogeneous Expectations Homogeneous Business Risk Classes Perpetual Cash Flows Perfect Capital Markets: Perfect competition Firms and investors can borrow/le