Chapter 16 – Financial Leverage and Capital Structure Policy
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Chapter 16
FINANCIAL LEVERAGE AND CAPITAL STRUCTURE
POLICY
CHAPTER WEB SITES
Section
Web Address
CHAPTER ORGANIZATION
16.2 The Effect of Financial Leverage
16.3 Capital Structure and the Cost of Equity Capital
16.4 M&M Propositions I and II with Corporate Taxes
Conclusion
16.5 Bankruptcy Costs
16.6 Optimal Capital Structure
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16.7 The Pie Again
16.8 The Pecking-Order Theory
16.10 A Quick Look at the Bankruptcy Process
16.11 Summary and Conclusions
ANNOTATED CHAPTER OUTLINE
16.1. The Capital Structure Question
A. Firm Value and Stock Value: An Example
B. Capital Structure and the Cost of Capital
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Lecture Tip: Students sometimes fail to understand the mechanics
16.2. The Effect of Financial Leverage
A. The Basics of Financial Leverage
Example (additional example from the one in the book)
Current capital structure: No debt
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Lecture Tip: You may wish to provide the following example to
We can conclude that:
Lecture Tip: Many students feel that if a company expects to
B. Corporate Borrowing and Homemade Leverage
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Recession
Expected
Expansion
The investor has been able to convert her return to what she would
Recession
Expected
Expansion
EPS – levered firm
Earnings for 25 shares
Plus interest on $250 at 10%
Net earnings
Return on investment = net earnings / $500
In this case, the investor is able to earn the same return as she
would have earned if the firm did not change capital structure and
she just invested in stock.
16.3. Capital Structure and the Cost of Equity Capital
EPS – unlevered firm
Earnings for 100 shares
Less interest on $500 at 10%
Net earnings
Return on investment = net earnings / $500
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Lecture Tip: Many students wonder why we are even considering
Lecture Tip: According to Proposition II,
C. Business and Financial Risk
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Lecture Tip: Some students may be confused by the concepts of
16.4. M&M Propositions I and II with Corporate Taxes
A. The Interest Tax Shield
B. Taxes and M&M Proposition I
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Lecture Tip: This is a good point at which to digress a bit on the
idea that financing decisions can generate positive NPVs. Put
C. Conclusion
As a firm increases its debt-equity ratio, WACC declines.
16.5. Bankruptcy Costs
Real-World Tip: In 1997, the remaining assets of Fruehauf
A. Direct Bankruptcy Costs
The key disadvantage of the use of debt is bankruptcy costs.
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B. Indirect Bankruptcy Costs
16.6. Optimal Capital Structure
A. The Static Theory of Capital Structure
B. Optimal Capital Structure and the Cost of Capital
C. Optimal Capital Structure: A Recap
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D. Capital Structure: Some Managerial Recommendations
International Note: In theory, the static model of capital structure
16.7. The Pie Again
A. The Extended Pie Model
B. Marketed Claims versus Nonmarketed Claims
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16.8. The Pecking-Order Theory
A. Internal Financing and the Pecking Order
B. Implications of the Pecking Order
16.9. Observed Capital Structures
16.10. A Quick Look at the Bankruptcy Process
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-Bankruptcy – the transfer of some, or all, of the firm’s assets to creditors
A. Liquidation and Reorganization
Lecture Tip: It has been said that Carl Icahn’s takeover of TWA in
B. Financial Management and the Bankruptcy Process
C. Agreements to Avoid Bankruptcy
16.11. Summary and Conclusions