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Chapter 16
Financial Leverage and Capital Structure Policy
McGraw-Hill/Irwin
Copyright © 2010 by The McGraw-Hill Companies, Inc. All rights reserved.
Key Concepts and Skills
• We can maximize stockholder wealth by maximizing the value of the firm or minimizing the WACC
16-5
The Effect of Leverage
• How does leverage affect the EPS and ROE of a firm?
16-7
Example: Financial Leverage, EPS and ROE – Part II
• Variability in ROE
– Current: ROE ranges from 6% to 20% – Proposed: ROE ranges from 2% to 30%
• Variability in EPS
16-6
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?
• Understand the effect of financial leverage on cash flows and the cost of equity
• Understand the impact of taxes and bankruptcy on capital structure choice
– Current: EPS ranges from $0.60 to $2.00 – Proposed: EPS ranges from $0.20 to $3.00
• The variability in both ROE and EPS increases when financial leverage is increased
• 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
• 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
• Understand the basic components of the bankruptcy process
16-2
Chapter Outline
• 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 • The Pie Again • The Pecking-Order Theory • Observed Capital Structures • A Quick Look at the Bankruptcy Process
• 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
16-3
Capital Restructuring
• We are going to look at how changes in capital structure affect the value of the firm, all else equal
• Capital restructuring involves changing the amount of leverage a firm has without changing the firm’s assets
16-4
Choosing a Capital Structure
• What is the primary goal of financial managers?
– Maximize stockholder wealth
• We want to choose the capital structure that will maximize stockholder wealth
16-8
Break-Even EBIT
• Find EBIT where EPS is the same under both the current and proposed capital structures
• If we expect EBIT to be greater than the break-even point, then leverຫໍສະໝຸດ Baiduge may be beneficial to our stockholders
Financial Leverage and Capital Structure Policy
McGraw-Hill/Irwin
Copyright © 2010 by The McGraw-Hill Companies, Inc. All rights reserved.
Key Concepts and Skills
• We can maximize stockholder wealth by maximizing the value of the firm or minimizing the WACC
16-5
The Effect of Leverage
• How does leverage affect the EPS and ROE of a firm?
16-7
Example: Financial Leverage, EPS and ROE – Part II
• Variability in ROE
– Current: ROE ranges from 6% to 20% – Proposed: ROE ranges from 2% to 30%
• Variability in EPS
16-6
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?
• Understand the effect of financial leverage on cash flows and the cost of equity
• Understand the impact of taxes and bankruptcy on capital structure choice
– Current: EPS ranges from $0.60 to $2.00 – Proposed: EPS ranges from $0.20 to $3.00
• The variability in both ROE and EPS increases when financial leverage is increased
• 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
• 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
• Understand the basic components of the bankruptcy process
16-2
Chapter Outline
• 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 • The Pie Again • The Pecking-Order Theory • Observed Capital Structures • A Quick Look at the Bankruptcy Process
• 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
16-3
Capital Restructuring
• We are going to look at how changes in capital structure affect the value of the firm, all else equal
• Capital restructuring involves changing the amount of leverage a firm has without changing the firm’s assets
16-4
Choosing a Capital Structure
• What is the primary goal of financial managers?
– Maximize stockholder wealth
• We want to choose the capital structure that will maximize stockholder wealth
16-8
Break-Even EBIT
• Find EBIT where EPS is the same under both the current and proposed capital structures
• If we expect EBIT to be greater than the break-even point, then leverຫໍສະໝຸດ Baiduge may be beneficial to our stockholders