Write an assessment in which you address the following problems/questions: Evalu
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Question
Write an assessment in which you address the following problems/questions:
Evaluate the leverage implications of debt financing choices. You should include in your discussion the decomposition of ROE model. There are also some graphical analyses that should be used in showing the leverage implications for EPS. You should develop some numerical illustrations to argue your points.
Critique the capital structure theory by explaining the conditions with and without taxes as well as the implications of bankruptcy costs. There should be the development of graphical illustrations of the arguments. Include a discussion of signaling theory, the constraining managers’ theory, the pecking order hypotheses, and the windows of opportunity theory.
Compare and contrast the actual debt choices that firms tend to make, including how the choices seem to adjust across industries. Describe why you believe that some industries make use of a lot of debt, while others use very little.
Explanation / Answer
Solution-
Introduction
Implications of Debt financing
Leverage refers to the availability of debt in the capital structure. Capital structure of a company generally comprises of debt and owner’s fund. The capital of a firm can be financed with equity and debt. Bothe the financing options has its own implication on thee firm. Debt financing means borrowing money from outsider through issuing bonds or debentures and raising loan from bank. The debt financing involves fixed commitment of repayment of principal and interest. The Earnings of the firm are affected by the debt choices, as earnings are reduced by interest and the earning per share gets affected.
The return on equity also gets affected by the presence of debt in the capital structure as the return paid to shareholders also decreases. The Return on equity is made up of Net profit Margin, Asset turnover and Equity Multiplier. The only element which gets affected is Net Profit Margin.
We have presented below the data of a firm with and without debt in capital structure and its impact on Earning per share.
Let’s assume , that Earnings before Interest & Tax (EBIT) is $5000, Tax rate is 0, number of shares outstanding is 1000, par value $10 and company is planning to raise debt of $ 10000, at an interest rate 5%.
EPS, without debt
EPS, after debt
EBIT
5000
5000
Less: Interest
0
-500
EBT
5000
4500
Number of shares outstanding
1000
1000
Earnings per share
5.00
4.50
Return on Equity
50%
45%
We have presented the EBIT-EPS model graphically considering no taxes are paid.
Common Stock
Debt
EBIT
EPS
1000
0
5000
5.00
1000
2000
5000
4.90
1000
4000
5000
4.80
1000
6000
5000
4.70
1000
8000
5000
4.60
1000
10000
5000
4.5
In case of taxes and bankruptcy cost, the firm gets the tax shield on interest expenses and thus the earning per share gets affected. The trade-off theory assumes that there is a benefit if capital structure is comprised of debt. The theory recognizes the befit from tax on interest expenses, as dividend payment does not provide tax benefit. This theory is called MM approach II, which suggest that as the proportion of debt increases in the capital structure, return on equity increases. This is due to the fact that more leverage means more risk and thus shareholders demand a higher return on their investments. The debt equity ratio changes with the addition of debt in capital structure.Bankruptcy cost arises whenever a company raises fund through debt. It can significantly affect the cost of capital of the company. Whenever a company invests in debt, company is bound to make regular payments for interest which affect the company cash flow and earnings
Up to a certain level, the weighted average cost of capital decreases, but after the optimal capital structure, the weighted average cost will increases.
Let’s assume that Earnings before Interest & Tax (EBIT) is $5000, Tax rate is 40%, number of shares outstanding is 1000 and company is planning to raise debt of $ 10000, at an interest rate 5%.
EPS, without debt
EPS, after debt
EBIT
5000
5000
Less: Interest
0
-500
EBT
5000
4500
Less: Tax Expenses
2000
1800
EAT
3000
2700
Number of shares outstanding
1000
1000
Earnings per share
3.00
2.70
From the above table, we can see that with the introduction of debt, the earning per share has decreased from $3 to $2.70. We have presented a graph of EBIT-EPS model at different level of debt
Common Stock
Debt
EBIT
EPS
1000
0
500
0.30
900
2000
500
0.27
600
4000
500
0.30
500
6000
500
0.24
500
8000
500
0.12
The above graphs shows that as there is an increase in level of debt, which resulted in decrease in EPS at first instance, but after that EPS increases i.e. at $4000 debt and common stock of 600 shares, the EPS is $.30 which suggest that this is the indifference point or the optimum level of capital structure.
The firm can choose to raise funds through bonds and borrowing funds from banks. The actual debt choices which companies make depend upon the market interest rates and are adjusted through all the industries by raising funds from outside when interest rate are down.
Some industries make use of lot of debt as they provide a higher return to its shareholders and are on growing stage. The firm which depends more on debt are termed as risky investment but they are confident enough that they would be able to repay its interest and principal.
Some firms tend to play safely and does not depend more on outside funds and generally provides lower return on investments. Such firms generally ha a fear of bankruptcy r liquidity issues and this is the reason the company depends upon equity or internal funds.
Reference:
Baker, H. (2011). Capital structure & corporate financing decisions theory, evidence, and practice. Hoboken, N.J.: John Wiley& Sons.
Clayman, M. (2012). Corporate finance workbook: A practical approach (2nd ed.). Hoboken, N.J.: John Wiley & Sons.Israel, R. (1991).
Vernimmen, P. (n.d.). Corporate finance: Theory and practice (Fourth ed.)
Capital structure and the market for corporate control: The defensive role of debt financing. Journal of Finance, 1391-1409.
EPS, without debt
EPS, after debt
EBIT
5000
5000
Less: Interest
0
-500
EBT
5000
4500
Number of shares outstanding
1000
1000
Earnings per share
5.00
4.50
Return on Equity
50%
45%
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