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Probability
High risk
0
E(EBIT)
EBIT
14-3
14-4
Effect of operating
leverage
Rev.
$
TC
} Profit
TC
FC
FC
QBE
Sales
QBE
Sales
Probability
EBITL
EBITH
14-7
An example:
Illustrating effects of financial
leverage
Firm L
$10,000 of 12% debt
in assets
$20,000 in assets
rate 40% tax rate
14-9
Firm U: Unleveraged
Economy
Bad
Avg.
Good
Prob.
0.25
EBIT
$2,000
Interest
0
EBT
$2,000
Taxes (40%)
800
NI
$1,200
0.50
$3,000
0
$3,000
1,200
$1,800
0.25
$4,000
0
$4,000
1,600
$2,400
14-10
Firm L: Leveraged
Economy
Bad
Avg.
Good
Prob.*
0.25
EBIT*
$2,000
Interest
1,200
EBT
$ 800
Taxes (40%)
320
NI
$ 480
*Same as for Firm U.
0.50
$3,000
1,200
$1,800
720
$1,080
0.25
$4,000
1,200
$2,800
1,120
$1,680
14-11
FIRM L
BEP
ROE
TIE
15.0%
9.0%
20.0%
12.0%
15.0%
10.8%
2.50x
20.0%
16.8%
3.30x
14-12
2.5x
Risk Measures:
Firm U
Firm L
ROE2.12%
4.24%
CVROE
0.24 0.39
14-13
14-14
Conclusions
Sequence of events in a
recapitalization.
D/A
ratio
D/E
ratio
Bond
rating
rd
$0
--
--
250
0.125
0.143
AA
8.0%
500
0.250
0.333
9.0%
750
0.375
0.600
BBB
11.5%
1,000
0.500
1.000
BB
14.0%
14-18
14-19
80,000
$3.00
14-20
80,000- 10,000
$3.26
Sharesrepurchase
d
EBIT
$400,000
TIE
20x
Int Exp $20,000
14-21
80,000- 20,000
$3.55
Sharesrepurchase
d
EBIT
$400,000
TIE
8.9x
Int Exp $45,000
14-22
80,000- 30,000
$3.77
EBIT
$400,000
TIE
4.6x
Int Exp $86,250
14-23
80,000- 40,000
$3.90
Sharesrepurchase
d
EBIT
$400,000
TIE
2.9x
Int Exp $140,000
14-24
rs - g
rs
rs
D/A
ratio
D/E
ratio
Levere
d beta
rs
$0
0%
0%
1.00
12.00%
250
12.50
14.29
1.09
12.51
500
25.00
33.33
1.20
13.20
750
37.50
60.00
1.36
14.16
1,000
50.00
100.00
1.60
15.60
14-30
Minimizes WACC.
Maximizes stock price.
borrowe
d
ratio
ratio
$0
0%
100%
12.00
%
--
12.00
%
250
12.50
87.50
12.51
4.80%
11.55
500
25.00
75.00
13.20
5.40%
11.25
750
37.50
62.50
14.16
6.90%
11.44
1,000
50.00
50.00
15.60
8.40%
12.00
14-32
borrowe
d
$0
$3.00
12.00
%
$25.00
250
3.26
12.51
26.03
500
3.55
13.20
26.89
750
3.77
14.16
26.59
1,000
3.90
15.60
25.00
14-33
14-34
Sales stability?
High operating leverage?
Increase in the corporate tax rate?
Increase in the personal tax rate?
Increase in bankruptcy costs?
Management spending lots of
money on lavish perks?
14-38
Modigliani-Miller Irrelevance
Theory
Value of Stock
MM result
Actual
No leverage
0
D1
D2
D/A
14-39
Modigliani-Miller Irrelevance
Theory
14-40
Incorporating signaling
effects
Assumptions:
Conclusions on Capital
Structure