Chapter 16, capital structure policy. After studying this chapter you will be able to: Explain how financial leverage affects earnings per share (EPS) and return on equity (ROE), compute the degree of financial leverage, define and compute the indifference earnings before interest and taxes (EBIT) and explain its importance in selecting between alternative financing opportunities, define and explain the term homemade leverage, explain why determining the optimal capital structure is important,. | Fundamentals of Corporate Finance, 3/e Robert Parrino, . David S. Kidwell, . Thomas W. Bates, . 1 Copyright© 2015 John Wiley & Sons, Inc. Chapter 16: Capital Structure Policy Learning Objectives Describe the two Modigliani and Miller propositions, the key assumptions under-lying them, and their relevance to capital structure decisions; use Proposition 2 to calculate the return on equity Discuss the benefits and costs of using debt financing and calculate the value of the income tax benefit associated with debt Copyright© 2015 John Wiley & Sons, Inc. 3 Learning Objectives Describe the trade-off and pecking order theories of capital structure choice and explain what the empirical evidence tells us about these theories Discuss some of the practical considerations that managers are concerned with when they choose a firm’s capital structure Copyright© 2015 John Wiley & Sons, Inc. 4 Capital Structure and Firm Value A firm’s capital structure is the mix of financial securities used to finance its activities The mix will always include common stock and will often include debt and preferred stock The firm may have several classes of common stock, for example with different voting rights and possibly different claims on the cash flows available to stockholders Capital Structure and Firm Value The debt at a firm can be long term or short term, secured or unsecured, convertible or not convertible into common stock, and so on Preferred stock can be cumulative or noncumulative and convertible or not convertible into common stock The fraction of the total financing that is represented by debt is a measure of the financial leverage in the firm’s capital structure Capital Structure and Firm Value A higher fraction of debt indicates a higher degree of financial leverage The amount of financial leverage in a firm’s capital structure is important because it affects the value of the firm Optimal Capital Structure Managers at a firm choose a capital structure so that the . | Fundamentals of Corporate Finance, 3/e Robert Parrino, . David S. Kidwell, . Thomas W. Bates, . 1 Copyright© 2015 John Wiley & Sons, Inc. Chapter 16: Capital Structure Policy Learning Objectives Describe the two Modigliani and Miller propositions, the key assumptions under-lying them, and their relevance to capital structure decisions; use Proposition 2 to calculate the return on equity Discuss the benefits and costs of using debt financing and calculate the value of the income tax benefit associated with debt Copyright© 2015 John Wiley & Sons, Inc. 3 Learning Objectives Describe the trade-off and pecking order theories of capital structure choice and explain what the empirical evidence tells us about these theories Discuss some of the practical considerations that managers are concerned with when they choose a firm’s capital structure Copyright© 2015 John Wiley & Sons, Inc. 4 Capital Structure and Firm Value A firm’s capital structure is the mix of financial securities .
