FIN 3400 Chapter 16

The total systematic risk of a firm's equitty has two parts. What are they?

1. Business risk 2. Financial Risk

Prop II: What are the three determinants of a firm's cost of equity?

1. the required rate of return on the firm's assets - Ra 2. the firms cost of debt - Rd 3. the firm's debt-equity ratio - D/E

What is the impact of financial leverage on stockholders?

A high degree of financial leverage means high interest payments, which negatively affect the company's bottom-line earnings per share. Financial risk is the risk to the stockholders that is caused by an increase in debt and preferred equities in a company's capital structure.

What does break-even EBIT tell us?

At any EBIT above the break even point, the increased financial leverage will increase EPS this tells us the minimum level for EBIT

EPS Formula

EPS = net income / shares outstanding Net income = EBIT - Interest

What does M&M proposition 1 state?

It is completely irrelevant how a firm chooses to arrange its finances Assets of two identical companies will be valued the same no matter what the debt to equity ratio the size of the pie doesn't depend on how it is sliced

ROE

Net income/ total equity

formula for prop II

RE = RA + (RA - RD) * (D/E)

Financial leverage

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

Discount Rate

The discount rate also refers to the rate used to determine the present value of cash flows in discounted cash flow analysis. For example, to determine the present value of $1,000 a year from now, you need to discount it by a particular interest rate. Assuming a discount rate of 10%, the present value would be $909.09

Relationship between EBIT and financial leverage

The effect of financial leverage depends on the company's EBIT. When EBIT is relatively high, leverage is beneficial.

What is homemade leverage?

The use of personal borrowing to alter the degree of financial leverage shareholders can adjust the amount of financial leverage by borrowing and lending on their own

Why should financial managers choose the capital structure that maximizes the value of the firm

The value of the firm is maximized when the WACC is minimized

Value of levered company formula

VL = VU + TC * D

Value with prop I

Value of Levered firm, VL, exceeds the value of unlevered firm by the present value of the interest tax shield (Tc *D)

What is the relationship between the WACC and the value of the firm

Values and discount rates moves in move in opposite directions, minimizing the WAXX will maximize the value of the firm's cash flows WACC = appreciate Discount rate

Why is Trans Am's capital structure irrelevant

Whichever capital structure Trans Am choses, the stock price will be the same There is nothing special about corporate borrowing because investors can borrow or lend their own

Financial risk

depends on financial policy the extra risk that arises from the use of debt financing the frim's cost of equity rises when the firm increases its use of financial leverage because the financial risk of the equity increases while the business risk stays the same

Business Risk

depends on the firm's assets and operations and is unaffected by capital structure the greater a firm's businesses risk, the greater RA will be --> and the greater the firm's cost of equity

What is WACC

is a calculation of a firm's cost of capital in which each category of capital is proportionately weighted. All sources of capital, including common stock, preferred stock, bonds and any other long-term debt

When EPS and ROE are higher with debt...

leverage increases the return to shareholders

pros and cons of debt

pro: interest paid on debt is tax deductible con: failure to meet debt obligations can result in bankruptcy

Interest Tax Shield

tax saving attained by a firm from interest expense

What is the optimal Capital Structure

the chief goal of any corporate finance department should be to find the optimal capital structure that will result in the lowest WACC and the maximum value of the company (shareholder wealth).

more debt means more risk to shareholders because...

EPS and ROE are much more sensitive to changes in EBIT in this case