Financial Leverage and Capital Structure Policy 1
to increase leverage (cooked up) + decrease the leverage
-find security, borrow from bank, buy security -hold less of the desirable security and allocate some of your portfolio to the risk free asset
financial leverage
debt in relation to a firm's capital structure: normally measured with D/E ratio, or D/V
when income is higher, a more highly levered firm has relatively ___________ EPS and ROE
greater
the variability of REO and EPS ________ as the degree of financial leverage increases
increases
First proof of MM proposition I
investor has two ways to obtain leverage: buy shares from levered firm, buy shares of unlevered firm and borrow on your personal account. both strategies generate identical future cash flows and risk in next period. same cash flows today. otherwise, arbitrage exists
MM Proposition I assumptions
no taxes, no capital market imperfections, the CFs are independent of financing sources
leverage ratio is ______ related to _____ variability and thus makes the firm more _______
positively, EPS, risky
when EBIT is high, financial leverage _________ ROE and EPS when EBIT is low, financial leverage ___________ ROE and EPS
raises lowers
arbitrage means
riskless profits without cash outlay, 100% certainty
MM Proposition I
the value of a firm is independent of its capital structure, Vl=Vu