In this chapter you will 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 bankruptcy. | Chapter 13 Lecture - Leverage and Capital Structure Chapter 13 Lecture - Leverage and Capital Structure Capital Structure • Capital structure = percent of debt and equity used to fund the firm’s assets – “Leverage” = use of debt in capital structure • Capital restructuring = changing the amount of leverage without changing the firm’s assets – Increase leverage by issuing debt and repurchasing outstanding shares – Decrease leverage by issuing new shares and retiring outstanding debt 13-1 13-2 Capital Structure & Shareholder Wealth Business Risk versus Financial Risk • Business risk: • The primary goal of financial managers: – Maximize stockholder wealth • Maximizing shareholder wealth = – Maximizing firm value – Minimizing WACC • Objective: Choose the capital structure that will minimize WACC and maximize stockholder wealth – Uncertainty in future EBIT. – Depends on business factors such competition, operating leverage, etc. as • Financial risk: – Additional business risk concentrated on common stockholders when financial leverage is used. – Depends on the amount of debt and preferred stock financing. 13-3 13-4 1 Chapter 13 Lecture - Leverage and Capital Structure Business Risk: Uncertainty about Future Pre-tax Operating Income (EBIT) Business Risk • The variability or uncertainty of a firm’s operating income (EBIT). EBIT FIRM EPS Stockholders Probability Low risk High risk Affected by: Sales volume variability Competition Cost variability Product 0 Diversification Product demand Operating Leverage E(EBIT) EBIT Note that business risk focuses on operating income, so it ignores financing effects. 13-5 13-6 Financial Risk So What Exactly is Leverage? Ability to influence a system, or an environment, in a way that multiplies the outcome of one's efforts without a corresponding increase in the consumption of resources. In other words, leverage is an advantageous-condition of having a relatively small amount of cost yield a relatively .
