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CAPITAL STRUCTURE

CAPITAL STRUCTURE. CAPITAL STRUCTURE. CAPITAL STRUCTURE IS A FIRM’S MIX OF DIFFERENT SECURITIES DEBT & EQUITY CASH FLOWS ARE SPLIT INTO TWO STREAMS SAFE STREAM TO BONDHOLDERS RISKY STREAM TO STOCKHOLDERS

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CAPITAL STRUCTURE

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  1. CAPITAL STRUCTURE

  2. CAPITAL STRUCTURE • CAPITAL STRUCTURE IS A FIRM’S MIX OF DIFFERENT SECURITIES • DEBT & EQUITY • CASH FLOWS ARE SPLIT INTO TWO STREAMS • SAFE STREAM TO BONDHOLDERS • RISKY STREAM TO STOCKHOLDERS • OBJECTIVE IS TO FIND THE MIX OF DEBT & EQUITY THAT MAXIMIZES THE FIRM’S OVERALL MARKET VALUE • FUNDAMENTALLY A MARKETING PROBLEM • IS IT WORTHWHILE TO TRY TO FIND OPTIMAL MIX? • PERHAPS THE MIX DOESN’T MATTER!

  3. CAPITAL STRUCTURE: OBJECTIVES • Explore the use of EBIT-EPS analysis as a tool of capital structure management • Examine theories of optimal capital structure, ie the relationship between capital structure and firm value • Understand the importance of the capital structure decision for a firm

  4. FINANCIAL STRUCTURE vs CAPITAL STRUCTURE • FINANCIAL STRUCTURE is the mix of all items that appear on the liabilities’ side of the firm’s balance sheet • CAPITAL STRUCTURE refers to the long-term sources of funds used by the firm

  5. BUSINESS RISK & FINANCIAL RISK • BUSINESS RISK the equity risk that comes from the nature of the firm’s operations • FINANCIAL RISK the equity risk that comes from the financial policy (ie the capital structure) of the firm

  6. EBIT-EPS ANALYSIS • The objective of EBIT-EPS analysis is to find the EBIT level that will equate EPS regardless of the financing plan chosen. • The limitation of EBIT-EPS analysis is that it considers only the level of the earnings stream and ignores risk.

  7. Calculation of Break-Even EBIT • EPS = (EBIT-I)(1-T)/No. of shares • Company A (no debt) (EBIT-0)(1-0.4)/4 million • Company B (with debt) (EBIT-£200,000)(1-0.4)/2 million • These are equal when: (EBIT-0)(1-0.4)/4 million= (EBIT-£200,000)(1-0.4)/2 million • With a little algebra, EBIT = £400,000

  8. EBIT-EPS ANALYSIS: SUMMARY • The effect of financial leverage depends upon EBIT • When EBIT is high, financial leverage raises EPS and ROE • The variability of EPS and ROE is increased with financial leverage

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