Lecture 13. Financial Leverage and Capital Structure. Key Concepts and Skills. Understand the effect of financial leverage on cash flows and cost of equity Understand the impact of taxes and bankruptcy on capital structure choice Understand the basic components of the bankruptcy process.
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Investor borrows $2000 and uses $2000 of their own to buy 200 shares of stock
Recession: 200(1.25) - .1(2000) = $50
Expected: 200(2.50) - .1(2000) = $300
Expansion: 200(3.75) - .1(2000) = $550
Mirrors the payoffs from purchasing 100 shares from the firm under the proposed capital structure
Proposed Capital Structure
Investor buys $1000 worth of stock (50 shares) and $1000 worth of Trans Am bonds paying 10%.
Recession: 50(.50) + .1(1000) = $125
Expected: 50(3.00) + .1(1000) = $250
Expansion: 50(5.50) + .1(1000) = $375
Mirrors the payoffs from purchasing 100 shares under the current capital structureExample: Homemade Leverage and ROE