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;INTENDED LEARNING OUTCOMES;TOPIC OUTLINE;iii. Static Trade
Off Theory
iv. Other Theories
v. Evidence Implications;CAPITAL STRUCTURE;SIGNIFICANCE;GEARING;IMPACT OF DEBT FINANCING;Fulthor plc is to be set up with a total capital of £10 million. Expected results for the company depend on trading conditions shown below:
Trading Conditions Poor Normal Good
EBIT (£000) 600 1,500 2,400
ROCE 6% 15% 24%
Three possible financing structures are being considered:
i. Gearing 0% (Equity 10 million £1 shares)
ii. Gearing 20% (Equity 8 million £1 shares, 10% Debt £2 million)
iii. Gearing 60% (Equity 4 million £1 shares, 10% Debt £6 million);i. Gearing 0%
EBIT 600 1,500 2,400 Shareholder Earnings 600 1,500 2,400
EPS (pence) 6 15 24
Return on Equity 6% 15% 24%
ii. Gearing 20%
EBIT 600 1,500 2,400
Debt Interest 200 200 200
Shareholder Earnings 400 1,300 2,200
EPS (pence) 5 16.25 27.5
Return on Equity 5% 16.25% 27.5%;iii. Gearing 60%
EBIT 600 1,500 2,400
Debt Interest 600 600 600
Shareholder Earnings 0 900 1,800
EPS (pence) 0 22.5 45
Return on Equity 0% 22.5% 45%;Return on Equity %
45 60% gearing
42
39
36
33
30
27 20% gearing
24 0% gearing
21
18
15
12
9
6
3
0
0 2 4 6 8 10 12 14 16 18 20 22 24 ROCE%;ASSUMPTIONS;MEASURES OF COST OF CAPITAL;THE CAPITAL STRUCTURE DEBATE;MODIGLIANI-MILLER HYPOTHESIS;PROPOSITIONS
1. The total value of the firm is independent of its capital structure.
2. The cost of equity increases to exactly offset any benefits from increased use of cheaper debt.
3. The cut-off rate for investment appraisal is independent of the firm’s capital structure and therefore of the way in which the project is financed.;
ke
Cost of
Capital
ko
kd
Leverage (Vd/Ve)
Cost of Capital under Modigliani-Miller Hypothesis ;The cost of equity increases to exactly offset any benefits from increased use of cheaper debt. The cost of equity for a geared firm is
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