chapter 13 Q 1

Financial leverage:

the extent to which a firm relies on debt. a. The more debt a financing firm uses in its capital structure, the more financial leverage it employs.

No Tax:

1) Under Prop I o A firm's capital structure is irrelevant o WACC is the same no matter what mixture of debt and equity is used to finance the firm. 2) Under Prop II: o cost of equity rises as the firm increases its sue of debt financing. o Risk of equity depends on Riskiness of the firm's operations The degree of financial leverage

Tax:

1) Under Prop I o Debt financing is highly advantageous, and, in the extreme, a firm's optimal capital structure is 100% of debt. o A firm's WACC, decreases as the firm relies more heavily on debt financing. o The value of the firm increases as total debt increases because of the interest tax shield. (so once we include taxes, capital structure matters*).

M&M Proposition II: (WACC):

A firm's cost of Equity Capital is a positive linear function of its capital structure. - The WACC of the firm is NOT affected by capital structure o Tells us that the cost of equity depends on three things: 1) Required Rate of Return on the firm's assets (RA) 2) The firm's Cost of Debt (RD) 3) The firm's debt-equity Ratio (D/E).

Financial leverage can impact SH's gains and losses.

o EPS vs EBIT (Leverage amplifies the variation in both EPS and ROE) o When EBIT is high leverage is beneficial o Leverage increases the returns to SHs, as measured by ROE and EPS. o SH's are exposed to more risk under the proposed capital structure since the EPS and the ROE are much more sensitive to changes in EBIT (in that case).

M&M Proposition I: (the Pie Model):

o The value of the firm is independent of its capital structure. o "The size of the pie doesn't depend on how it's sliced." o The cash flows of the firm do not change; therefore, value doesn't change

Homemade Leverage:

SH's can adjust the amount of financial leverage by borrowing and lending on their own. --> It's the use of personal borrowing to alter the degree/overall amount of financial leverage to which the individual is exposed. • Leverage amplifies the variation in both EPS and ROE.