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Capital Structure

In: Business and Management

Submitted By miaomiao7095
Words 1526
Pages 7
Capital Structure – Chapt. 16 in text

Does Capital Structure affect firm value?

MM Proposition I (No Taxes):

The value of a levered firm is equal to the value of an unlevered firm. VL = VU. i.e., Financing Choices do not add value. Why? Because you can create homemade leverage if you wish.

• Unlevered Firm vs. a Levered Firm with the same assets.

Recapitalization of Trans Am Corporation. Debt issue of $4,000,000 at 10% to buy back equity. Alternatively, you may view them as two companies that differ only in their capital structure.

Current Proposed

Assets $8,000,000 8,000,000
Debt 0 4,000,000
Equity 8,000,000 4,000,000
Shares Outstanding 400,000 200,000
Share price $20 $20

Trans Am Corporation - without debt

Recession Expected Boom

Earnings: 400,000 1,200,000 2,000,000

Interest: 0 0 0

Earnings after interest: 400,000 1,200,000 2,000,000

Return on equity (ROE): 5% 15% 25%

EPS: $1.00 $3.00 $5.00

Trans Am Corporation - with debt

Recession Expected Boom

Earnings: 400,000 1,200,000 2,000,000

Interest: 400,000 400,000 400,000

Earnings after interest: 0 800,000 1,600,000

Return on equity (ROE): 0% 20% 40%

EPS: $0 $4.00 $8.00

Payoffs with Levered Firm and Homemade Leverage

Recession Expected Boom
Buy 100 shares of
Levered Equity at
Cost of $2,000

EPS $0 $4.00 $8.00

Earnings for
100 shares 0 400 800

Homemade Leverage
Borrow $2,000 at
10% to buy 200
Shares of Unlevered
Firm

EPS 1 3 5

Earnings for
200 shares 200 600 1,000

Interest Due 200 200 200
Net Earnings 0 400 800

Observations:

1. The EPS and ROE of a firm with Debt is more variable (Riskier) than the EPS and ROE of firm without Debt.

2.

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