The Basics of Financial Leverage

We start by illustrating how financial leverage works. For now, we ignore the impact of taxes. Also, for ease of presentation, we describe the impact of leverage in terms of its effects on earnings per share, EPS, and return on equity, ROE. These are, of course, accounting numbers and, as such, are not our primary concern. Using cash flows instead of these accounting numbers would lead to precisely the same conclusions, but a little more work would be needed. We discuss the impact on market values in a subsequent section.

Financial Leverage, EPS, and ROE: An Example The Trans Am Corporation currently has no debt in its capital structure. The CFO, Ms. Morris, is considering a restructuring that would involve issuing debt and using the proceeds to buy back some of the outstanding equity. Table 17.3 presents both the current and proposed capital structures. As shown, the firm's assets have a market value of $8 million, and there are 400,000 shares outstanding. Because Trans Am is an all-equity firm, the price per share is $20.

The proposed debt issue would raise $4 million; the interest rate would be 10 percent. Because the stock sells for $20 per share, the $4 million in new debt would be used to purchase $4 million/20 = 200,000 shares, leaving 200,000. After the restructuring, Trans Am would have a capital structure that was 50 percent debt, so the debt-equity ratio would be 1. Notice that, for now, we assume that the stock price will remain at $20.

To investigate the impact of the proposed restructuring, Ms. Morris has prepared Table 17.4, which compares the firm's current capital structure to the proposed capital structure under three scenarios. The scenarios reflect different assumptions about the

Ross et al.: Fundamentals of Corporate Finance, Sixth Edition, Alternate Edition

VI. Cost of Capital and Long-Term Financial Policy

17. Financial Leverage and Capital Structure Policy

© The McGraw-Hill Companies, 2002

CHAPTER 17 Financial Leverage and Capital Structure Policy

Current Capital Structure: No Debt

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