FINANCE IN A CANADIAN SETTING Sixth Canadian Edition. Lusztig, Cleary, Schwab. CHAPTER SIXTEEN Capital Structure. Learning Objectives. 1. Describe leverage and how it affects companies. 2. Define indifference analysis, how it is used, and what it measures.
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Lusztig, Cleary, Schwab
1. Describe leverage and how it affects companies.
2. Define indifference analysis, how it is used, and what it measures.
3. Explain how the value of a company is established.
4. Name two reasons why the cost of a security to a company differs from its yield in capital markets.
5. Describe how debt capacity affects a company.
Operating and Financial Leverage
Value of firm = value of debt + value of equity
1. It ignores cash flow considerations such as sinking fund provisions for the periodic retirement of fixed income securities.
2. It does not consider how equity investors may react to the increased risk imposed by leverage in the light of uncertain future operating performance.
market price per share, WACC
market price per share, WACC
1. Cost equity increases with leverage at a moderate rate so that when combined with debt
2. Cost of equity increases at a rate that offsets the benefits gained through cheaper financing
3. Cost of equity increases rapidly with leverage and increase more than offsets any gains from debt
Consequences of Different Shareholder Attitudes Toward Risk
The Traditional Position on Capital Structure and the Cost of Capital
Relationship Between the WACC, Cost of Equity, and Leverage
Present value of tax savings =
Total after-tax distribution
Cash Flow with Corporate and Personal Taxes
1. the direct costs such as fees for trustees, lawyers, and court proceedings
2. the loss of profits caused by the loss of trust in the company
Benefit of Tax Savings, Expected Bankruptcy Costs, and Optimal Capital Structure
1. Retained earnings or depreciation should be used first
2. After internal resources are depleted, debt should be used
3. New common equity should be issued only when more debt is likely to increase the chance of bankruptcy
1. A firm that incurs fixed costs while generating variable revenues is subject to leverage. Leverage is used to increase the expected profitability of a firm. Financial risk is the added variability in returns to shareholders introduced by financing through fixed-cost senior securities.
2. Indifference analysis is used to evaluate the effect of leverage on profitability.
3. A firm’s capital structure is optimal if it maximizes shareholder wealth. The desirability of financial leverage depends on equity investors’ attitudes toward the implied trade-offs between risk and expected returns. The traditional position suggests, optional moderate leverage.
4. Given corporate taxes, interest on debt allows the firm to reduce its tax bill and to increase the amount available for distribution to security holders.
5. Firms restrict debt financing in order to limit the probability of financial distress. Liquidation decisions entail capital budgeting analysis that is based on net present values. Total expected bankruptcy costs increase with financial leverage and reduce the value of the firm. The trade-off facing management is between the tax benefits that accrue through debt financing and the expected costs of financial distress that increase with leverage.
6. Since debt payments represent contractual obligations, high leverage reduces a firm’s free cash flow. It thus limits management flexibility and discretion. A firm’s debt capacity is mainly a function of the stability of its cash flow and its collateral’s value and liquidity.
7. Financial leverage affects a firm’s systematic risk. Beta, as specified by the Capital Asset Pricing Model, varies as a function of the debt proportion that the firm employs.