chapter 14 establishing a target capital structure

8/14/2019 Chapter 14 Establishing a Target Capital Structure

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© Drs. Y. Starreveld

1

Chapter 14

Establishing a Target Capital

Structure




2

Capital Structure

Current Assets

Fixed Assets

Long Term Liabilities

Short Term Liabilities

Balance Sheet

Owner’s Equity




3

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.




4


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.




5


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




6

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




7

The MM’s Proposition II -A Graphical Representation

Debt / Equity

R

equir

edreturn

(k0 )

(ke )

(kd )


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8

Effects of Financial Leverage on ROE

25 100 CapitalStructure

ROA = 10

i = 8

D e b t

E q ui t y



9


25 100 CapitalStructure

ROE = 16

ROA = 10

i = 8

D e b t

E q ui t y



10


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



11

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



12


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



13


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



14


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



15


ROA-ROE Relationship anFinancial leverage

-10

0

10

20

30

-0.02 0.08 0.18

ROA

R O E No debt

50% Debt



16

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



17

Hi-Tech’s EBIT - EPS IndifferencePoint

000,500$EBIT

000,250

)]50.0)(000,250EBIT[(

000,500

)]50.0)(0EBIT[(

Debt Stock

*

**

=

−

=

−

chapter 14 establishing a target capital structure

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