Unit 9
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Transcript of Unit 9
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Unit 9
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Capital Structure
Optimal Capital Structure: The firm’s capital structure that maximizes its stock price.
Target Capital Structure: The mix of debt, preferred stock, and common equity with which the firm plans to raise capital.
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Primary Factors That Influence Capital Structure
Business riskTax positionFinancial flexibilityManagerial conservation or aggressiveness
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Operating Breakeven
The output quantity at which EBIT=0.
EBIT = PQ – VQ- F
P= average sales price per unit of outputQ= outputV= variable cost per unitF= Fixed operating costs
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Example
McDonald Electronics will produce 60,000 stereos next year. Variable costs will equal 50% of sales, while fixed costs will total $120,000. At what price must each stereo be sold for the company to achieve an EBIT of $95,000?
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Answer
EBIT = PQ-VQ-F
$95,000= P*60,000 - .5P *60,000-$120,000$215,000=60,000P-30,000P$215,000=30,000PP= $7.17
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Example
Fletcher Corp. has a capital budget of $1,000,000, but it wants to maintain a target capital structure of 60% debt and 40% equity. The company forecasts this year’s net income to be $600,000. If the company follows a residual dividend policy, what will be its dividend paid?
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Answer
With a capital budget of $1 M and a capital structure that is 40% equity requires $400,000 in retained earnings. This means the dividend that could be paid out of NI of $60,000 is:
Dividends= NI- [(target equity ratio)(total capital budget)]
Dividends= $600,000- [40% * $1,000,000]= $200,000
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Example
Rooney Inc. recently completed a 3 for2 stock split. Prior to the split, its stock price was $90 per share. The firm’s total market value was unchanged by the split. What was the price of the company’s stock following the stock split?
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Answer
$90*2/3= $60 price post split
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Example
Howard Contracting recently completed a 3-for-1 stock split. Prior to the split, its stock price was $150 per share. The firm's total market value was unchanged by the split. What was the price of the company’s stock following the stock split?
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Answer
150/3 = $50.00Stock split factor 3Pre-split stock price $150
Post-split stock price $50.00
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Example
Nistelroy Communications recently completed a 3-for-1 stock split. Prior to the split, its stock price was $120 per share. The firm's total market value increased by 5% as a result of the split. What was the price of the company’s stock following the stock split?
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Answer
120/3 = 40 x 1.05 = $42.00
Stock split factor 3Pre-split stock price $120Market reaction 5%
Post-split stock price $42.00
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Example
Young Enterprises has $2 million in assets, $400,000 of EBIT, and has a 40% tax rate. The firm also has a debt-to-assets ratio of 50% and pays 12% interest on its debt. What is Young's ROE?
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Answer
If Debt = $1,000,000 then equity = $1,000,000 Assets $2,000,000EBIT $400,000Tax rate 40%Debt ratio 50%Interest rate 12%
Firm A net income $168,000Firm A equity $1,000,000Firm A ROE 16.80%
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Example
Firms A and B are identical except for their level of debt and the interest rates they pay on debt. Each has $2 million in assets, $400,000 of EBIT, and has a 40% tax rate. However, firm A has a debt-to-assets ratio of 50% and pays 12% interest on its debt, while Firm B has a 30% debt ratio and pays only 10% interest on its debt. What is the difference between the two firms' ROEs?
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Answer
First we need to calculate the NI of the two firms:
Firm A: $400,000 – ($1M * .12) = $280,000 * (1 - .40) = $168,000
Firm B: $400,000 – ($600,000 * .10) = $340,000 * (1 - .40) = $204,000
Firm A equity = $2M * .50 = $1MFirm A ROE = $168,000 / $1M = 16.80%Firm B equity = $2M * .70 = $1.4MFirm B ROE = $204,000 / $1.4M = 14.57%Difference in ROEs = 16.80% - 14.57% = 2.23%