Chap016 capital structure-basic concepts.ppt

* The cash flow to all stakeholders is made up of cash flow to stockholders plus cash flow to bondholders. 16-* Capital Structure: Basic Concepts Chapter 16 Copyright ? 2010 by the McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Key Concepts and Skills Understand the effect of financial leverage (i.e., capital structure) on firm earnings Understand homemade leverage Understand capital structure theories with and without taxes Be able to compute the value of the unlevered and levered firm Chapter Outline 16.1 The Capital Structure Question and The Pie Theory 16.2 Maximizing Firm Value versus Maximizing Stockholder Interests 16.3 Financial Leverage and Firm Value: An Example 16.4 Modigliani and Miller: Proposition II (No Taxes) 16.5 Taxes 16.1 Capital Structure and the Pie 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 If the goal of the firm’s management is to make the firm as valuable as possible, then the firm should pick the debt-equity ratio that makes the pie as big as possible. Value of the Firm S B S B S B S B Stockholder Interests There are 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. 16.3 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 Proposed $20,000 $8,000 $12,000 2/3 8% 240 $50 Consider an all-equity firm that is contemplating going into debt. (Maybe some of the original shareholders want to cash out.) EPS and ROE Under Current Structure Recession Expected Expansion EBIT $1,000 $2,000 $3,000 Interest