Financial Leverage And Capital Structure Policy
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Chapter Outline

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The Capital Structure Question The Effect of Financial Leverage Capital Structure and the Cost of Equity Capital M&M Propositions I and II with Corporate Taxes Bankruptcy Costs Optimal Capital Structure

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Capital Restructuring
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We are going to look at how changes in capital structure affect the value of the firm, all else

equal
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Capital restructuring involves changing the amount of leverage a firm has without changing the firm’s assets  The firm can increase leverage by issuing debt and repurchasing outstanding shares  The firm can decrease leverage by issuing new shares and retiring outstanding debt 2

Choosing a Capital Structure
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What is the primary goal of financial managers?
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Maximize stockholder wealth

We want to choose the capital structure that will maximize stockholder wealth  We can maximize stockholder wealth by maximizing the value of the firm or minimizing the WACC
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How does leverage affect the EPS and ROE of a firm? When we increase the amount of debt financing, we increase the fixed interest expense If we have a really good year, then we pay our fixed cost and we have more left over for our stockholders If we have a really bad year, we still have to pay our fixed costs and we have less left over for our stockholders Leverage amplifies the variation in both EPS and ROE 4

The Effect of Leverage

Example: Financial Leverage, EPS and ROE – Part I
We will ignore the effect of taxes at this stage  What happens to EPS and ROE when we issue debt and buy back shares of stock?  ABC is a company with no debt in its current capital structure. The financial managers are proposing to restructure the company by issuing debts and buying back some of the outstanding shares.  Note that the EBIT is not