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Chapter Outcomes
10
Cost of Capital
Cost of debt
Cost of preferred stock
Cost of common equity
Retained earnings
New common stock
11
Cost of Debt
13
Recall:
rp = Dp / Pps
taking flotation costs into account,
cost of preferred stock
= kp = Dp / (Pps - Fps)
14
kp = Dp / (Pps - Fps)
15
16
Recall:
E (Ri) = RFR + i ( RMKT - RFR)
20
Interrelationships
Firms growth rate
Profitability
Dividend policy
23
24
26
EBIT/eps analysis
EBIT $6.00
Int 0.00
NI
$6.00
eps $ 1.50
EXPECTED
$12.00
0.00
$12.00
$ 3.00
EBIT 50%
ABOVE
EXPECTED
$18.00
0.00
$18.00
$ 4.50
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EBIT $6.00
Int 5.00
NI
$1.00
eps $ 0.50
EXPECTED
$12.00
5.00
$ 7.00
$ 3.50
EBIT 50%
ABOVE
EXPECTED
$18.00
5.00
$13.00
$ 6.50
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EBIT/eps analysis
Current versus Proposed
8 eps
Proposed
6
4
Current
2
0
-2
-4
10
12
15
18
EBIT
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Indifference Level
Indifference Level
EBIT/TA = interest cost (%)
If EBIT/TA > interest cost, higher
leverage is helpful (higher eps)
If EBIT/TA < interest cost, higher
leverage is harmful (lower eps)
33
Positives
Indicates EBIT values when one capital
structure may be preferred over another
Analysis of expected EBIT can focus on
the likelihood of actual EBIT exceeding
the indifference point
Drawbacks
Does not capture risk
Value-maximizing eps is probably less
than maximum eps (Figure 18.8)
34
Business Risk
37
DOL x DFL
38
Leverage Example
THIS
10% SALES
YEAR
INCREASE
Net sales $700,000$770,000
Less: variable costs
(60% of sales) 420,000
462,000
Less: fixed costs 200,000
200,000
EBIT 80,000
108,000
Less: interest
20,000
20,000
EBT
60,000
88,000
Less: taxes
18,000
26,400
Net income
$42,000$ 61,600
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Leverage Calculations
Percent change in sales
+10.0%
Percent change in EBIT
+35.0%
Percent change in net income +46.7%
DOL = 35% / 10% = 3.50
DFL = 46.7% / 35% = 1.33
DCL = 46.7% / 10% = 4.67
DCL = DOL x DFL = 3.50 x 1.33 = 4.67
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Debt:
convertible or straight
maturity: can be extended/shortened
interest: fixed or variable
Equity:
preferred stock
common stock
different classes of common stock
43
Business risk
Taxes and non-debt tax shields
Mix of tangible and intangible assets
Financial flexibility
Control of the firm
Profitability
Financial market conditions
Managements attitude toward debt
and risk
44
Web Links
www.ibbotson.com
www.mergent.com
www.sternstewart.com
www.stern.nyu.edu/~ealtman
www.cfo.com
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