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Capital Structure
2005 Thomson/South-Western
Probability Density
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$2.40
$3.36
EPS ($)
The Effect of Capital Structure on Stock Prices and the Cost of Capital
The optimal capital structure maximizes the price of a firms stock. The optimal capital structure always calls for a debt/assets ratio that is lower than the one that maximizes expected EPS.
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Stock Price and Cost of Capital Estimates with Different Debt/Assets Ratios
Debt/ kd Expected Estimated ks = [kRF + Estimated Resulting Assets EPS Beta Price P/E Ratio (kM kRF)s] 0% $2.40 1.50 12.0% $20.00 8.33 10 8.0% 2.56 1.55 12.2 20.98 8.20 20 8.3 2.75 1.65 12.6 21.83 7.94 30 9.0 2.97 1.80 13.2 22.50 7.58 40 10.0 3.20 2.00 14.0 22.86 7.14 50 12.0 3.36 2.30 15.2 22.11 6.58 60 15.0 3.30 2.70 16.8 19.64 5.95 WACC 12.00% 11.46 11.08 10.86 10.80 11.20 12.12
All earnings paid out as dividends, so EPS = DPS. Assume that kRF = 6% and kM = 10%. Tax rate = 40%. WACC = wdkd(1 - T) + wsks = (D/A) kd(1 - T) + (1 - D/A)ks
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Debt/Assets (%)
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Cost of Equity, ks
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WACC
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Minimum = 10.8%
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0 0 10 20 30 40 50 60
Debt/Assets (%)
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Maximum = $22.86
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19 18 0 10 20 30 40 50 60
Debt/Assets (%)
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DEBIT DEBIT DOL = Percentage change in NOI = EBIT = EBIT Percentage change in sales DSales DQ Sales Q Q(P - V) DOLQ = Q(P - V) - FC
DOLS = S - VC S - VC - F = Gross Profit EBIT
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2. Theory:
1. Interest rates rise as debt/asset ratio increases 2. Tax rates fall at high debt levels (lowers debt tax shield) 3. Probability of bankruptcy increases as debt/assets ratio increases.
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3.
4.
Between these two debt levels, the firms stock price rises, but at a decreasing rate
So, the optimal debt level = optimal capital structure
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Signaling Theory
Symmetric Information
Investors and managers have identical information about the firms prospects.
Asymmetric Information
Managers have better information about their firms prospects than do outside investors.
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Signaling Theory
Signal
An action taken by a firms management that provides clues to investors about how management views the firms prospects
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