Professional Documents
Culture Documents
Firm U Firm L
No debt $10,000 of 12% debt
$20,000 in assets $20,000 in assets
40% tax rate 40% tax rate
Both firms have same operating
leverage, business risk, and probability
distribution of EBIT. Differ only with
respect to use of debt (capital structure).
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13 - 3
Firm U Firm L
EBIT $3,000 $3,000
Interest 0 1,200
EBT $3,000 $1,800
Taxes (40%) 1 ,200 720
NI $1,800 $1,080
ROE 9.0% 10.8%
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Why does leveraging increase return?
High risk
0 E(EBIT) EBIT
Note that business risk does not include
financing effects.
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EBITL EBITH
Firm U: Unleveraged
Economy
Bad Avg. Good
Prob. 0.25 0.50 0.25
EBIT $2,000 $3,000 $4,000
Interest 0 0 0
EBT $2,000 $3,000 $4,000
Taxes (40%) 800 1,200 1,600
NI $1,200 $1,800 $2,400
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Firm L: Leveraged
Economy
Bad Avg. Good
Prob.* 0.25 0.50 0.25
EBIT* $2,000 $3,000 $4,000
Interest 1,200 1,200 1,200
EBT $ 800 $1,800 $2,800
Taxes (40%) 320 720 1,120
NI $ 480 $1,080 $1,680
*Same as for Firm U.
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8
Firm L Bad Avg. Good
BEP* 10.0% 15.0% 20.0%
ROE 4.8% 10.8% 16.8%
TIE 1.67x 2.5x 3.3x
*BEP same for Firms U and L.
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Expected Values:
U L
E(BEP) 15.0% 15.0%
E(ROE) 9.0% 10.8%
E(TIE) 2.5x
8
Risk Measures:
ROE 2.12% 4.24%
CVROE 0.24 0.39
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13 - 16
Conclusions
EBIT
TIE = .
Int
($400,000)(0.6)
= 80,000 = $3.00.
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D = $250, kd = 8%.
Shares $250,000
= = 10,000.
repurchased $25
[$400 0.08($250)](0.6)
EPS1 =
80 10
= $3.26.
EBIT $400
TIE = = = 20.
I $20
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D = $500, kd = 9%.
Shares $500
= = 20.
repurchased $25
[$400 0.09($500)](0.6)
EPS2 =
80 20
= $3.55.
EBIT $400
TIE = = = 8.9.
I $45
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D = $750, kd = 11.5%.
Shares $750
= = 30.
repurchased $25
[$400 0.115($750)](0.6)
EPS3 =
80 30
= $3.77.
EBIT $400
TIE = = = 4.6.
I $86.25
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D = $1,000, kd = 14%.
Shares $1,000
= = 40.
repurchased $25
[$400 0.14($1,000)](0.6)
EPS4 =
80 40
= $3.90.
EBIT $400
TIE = = = 2.9.
I $140
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D1 EPS DPS
P0 = = = .
ks g ks ks
bL = bU[1 + (1 T)(D/E)].
15 ks
WACC
kd(1 T)
P0
EPS
D/A
.25 .50
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If it were discovered that the firm had
more/less business risk than originally
estimated, how would the analysis be
affected?
1. Sales stability?
2. High operating leverage?
3. Increase in the corporate tax rate?
4. Increase in the personal tax rate?
5. Increase in bankruptcy costs?
6. Management spending lots of money
on lavish perks?
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13 - 44
Value of Stock
MM result
Actual
No leverage
D/A
0 D1 D2
Assumptions: