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Use of Debt
The use of debt increases the risk borne by
shareholders
However, using debt leads to higher
expected rates of return by shareholders.
The firms optimal capital structure is the
one that balances the influence of risk and
return and thus maximizes the firms stock
price.
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3. Financial flexibility
This is the firms ability to raise capital with
reasonable terms under adverse conditions.
The greater the probable future need for capital,
and the worse the consequences of a capital
shortage, the stronger the balance sheet should
be.
4. The conservatism or aggressiveness of
management
Firms with aggressive managers are more inclined
to use debt in an effort to boost profits.
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Operating breakpoint
The amount quantity at which Sales = Costs,
hence when EBIT = 0.
Sales = Costs
P*Q = V*Q + F
Where P is average sales price per unit of output,
Q is units of output, V is variable cost per unit
EBIT = PQ VQ- F = 0
Breakeven Q = F/(P-V)
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EX)
Plan A :F = $40,000, P =$4, V=$3, Assets = $ 400,000
Plan B: F = $120,000, P =$4, V=$2 Assets = $ 400,000
Rev.
TC
Profit
TC
FC
FC
QBE
Sales
QBE
Sales
10
Probability
EBITA
EBITB
11
12
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15
Firm U
No debt
$20,000 in assets
40% tax rate
Firm L
$10,000 of 12% debt
$20,000 in assets
40% tax rate
Firm U: Unleveraged
Bad
Prob.
0.25
EBIT
$2,000
Interest
0
EBT
$2,000
Taxes (40%)
800
NI
$1,200
Economy
Avg.
Good
0.50
0.25
$3,000 $4,000
0
0
$3,000 $4,000
1,200
1,600
$1,800 $2,400
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Firm L: Leveraged
Economy
Bad
Avg.
Good
Prob.*
EBIT*
Interest
EBT
Taxes (40%)
NI
0.25
$2,000
1,200
$ 800
320
$ 480
0.50
$3,000
1,200
$1,800
720
$1,080
0.25
$4,000
1,200
$2,800
1,120
$1,680
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Coefficient of variation
= standard deviation / expected return
CV shows standard measure of the risk per
unit of return, and it provides a more
meaningful basis for comparison when the
expected returns on two alternatives are not
the same.
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Firm L
Bad
Avg.
BEP*
10.0%
15.0%
ROE
4.8%
10.8%
TIE
1.67
2.5
*BEP same for Firms U and L.
Good
20.0%
12.0%
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Avg.
15.0%
9.0%
8
Bad
10.0%
6.0%
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Firm U
BEP*
ROE
TIE
Good
20.0%
16.8%
3.3
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Expected Values:
E(BEP)
E(ROE)
E(TIE)
U
15.0%
9.0%
L
15.0%
10.8%
2.5
Risk Measures:
sROE
CVROE
2.12%
0.24
4.24%
0.39
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Conclusions
Basic earning power = BEP = EBIT/Total
assets is unaffected by financial leverage.
L has higher expected ROE because BEP > kd.
L has much wider ROE (and EPS) swings
because of fixed interest charges. Its higher
expected return is accompanied by higher risk.
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