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