Professional Documents
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Financing Mix
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Independence Hypothesis: Independence Hypothesis:
Rix Camper Manufacturing Company Rix Camper Manufacturing Company
Capital Structure: 100% equity, no debt Capital Structure: 100% equity, no debt
Stock price: $10 per share Stock price: $10 per share
Shares outstanding: 2 million Shares outstanding: 2 million
Operating income (EBIT): $2,000,000 Operating income (EBIT): $2,000,000
Calculate EPS:
With no interest payments and no taxes,
EBIT = net income.
$2,000,000/2,000,000 shares = $1.00
Capital Structure: 60% equity, 40% debt Capital Structure: 60% equity, 40% debt
Stock price: $10 per share Stock price: $10 per share
Shares outstanding: 1.2 million Shares outstanding: 1.2 million
Net income: $2,000,000 - $480,000 = $1,520,000 Net income: $2,000,000 - $480,000 = $1,520,000
Calculate EPS:
$1,520,000/1,200,000 shares = $1.267
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Independence Hypothesis: Independence Hypothesis:
Rix Camper Manufacturing Company Rix Camper Manufacturing Company
Capital Structure: 60% equity, 40% debt Capital Structure: 60% equity, 40% debt
Stock price: $10 per share Stock price: $10 per share
Shares outstanding: 1.2 million Shares outstanding: 1.2 million
Net income: $2,000,000 - $480,000 = $1,520,000 Net income: $2,000,000 - $480,000 = $1,520,000
Calculate the Cost of Equity: Calculate the Cost of Capital:
D1 1.267
k = + g = + 0 = 12.67% .6 (12.67%) + .4 (6%) = 10%
P 10.00
kc . kc
kd kd
0% debt Financial Leverage 100% debt 0% debt Financial Leverage 100% debt
0% debt Financial Leverage 100% debt 0% debt Financial Leverage 100% debt
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Independence Hypothesis Dependence Hypothesis
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Moderate Position Moderate Position
Even if the cost of equity rises
kc The low cost of debt kc
Cost of as leverage increases, the Cost of
reduces the cost of
Capital cost of debt is Capital
very low... capital.
because
kc
of the tax benefit kc
associated with debt financing.
ko
kd kd kd kd
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Moderate Position Moderate Position
with Bankruptcy and Agency Costs with Bankruptcy and Agency Costs
Cost of Cost of
Capital Capital kc
kc kd kc kd
kd kd
Cost of kc Cost of kc
If a firm borrows too much, the
Capital Capital costs of debt and equity will spike
upward, due to bankruptcy costs
and agency costs.
kc kd kc kd
kd kd
Cost of kc Cost of kc
Capital Capital
kc kd kc kd
ko
kd kd
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Moderate Position Moderate Position
with Bankruptcy and Agency Costs with Bankruptcy and Agency Costs
Cost of kc Cost of kc
Ideally, a firm should use leverage
Capital Capital
to obtain their optimum capital
ko structure, which will minimize theko
kc kc
firm’s cost of capital.
kd kd
kd kd
kd
Financial Leverage
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If we expect EBIT to be $2,000,000: If we expect EBIT to be $4,000,000:
1 1
0 EBIT 0 EBIT
$1m $2m $3m $4m $1m $2m $3m $4m
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Breakeven Point Breakeven EBIT bond
financing
EPS
Stock Financing Debt Financing 3
For EBIT up to $3 million, stock
.6 EBIT = .6 EBIT - 360,000 stock financing is best. financing
1 .8 2
For EBIT greater
.48 EBIT = .6 EBIT - 360,000 than $3 million,
1 debt financing
.12 EBIT = 360,000 is best.
0 EBIT
EBIT = $3,000,000 $1m $2m $3m $4m
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In-class Problem Breakeven EBIT
Stock Financing Levered Financing
Plan A: Sell 1,200,000 shares at $20
per share ($24 million total). (EBIT-I) (1-t) - P = (EBIT-I) (1-t) - P
Plan B: Issue $9.6 million in 9% debt S S
and sell shares at $20 per share (EBIT-0) (1-.35) = (EBIT-864,000)(1-.35)
($24 million total).
1,200,000 720,000
Assume a 35% marginal tax rate.
EBIT = $2,160,000
0 EBIT
$1m $2m $3m $4m
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