maximizing firm value? Perhaps they should be interested in strategies that maximize shareholder value. 2. What is the ratio of debt-to-equity that maximizes the shareholder’s value?
2/3 8% 240 $50
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Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
15-4
EPS and ROE Under Current Capital Structure
As it turns out, changes in capital structure benefit the stockholders if and only if the value of the firm increases.
McGraw-Hill/Irwin
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Proposed Shares Outstanding = 240 shares
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Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
15-6
EPS and ROE Under Both Capital Structures
• V=B+S
• If the goal of the management of the firm is to make the firm as valuable as possible, the the firm should pick the debt-equity ratio that makes the pie as big as possible.
15-3
Financial Leverage, EPS, and ROE
Consider an all-equity firm that is considering going into debt. (Maybe some of the original shareholders want to cash out.)
Assets Debt Equity Debt/Equity ratio Interest rate Shares outstanding Share price
Current $20,000
$0 $20,000
0.00 n/a 400 $50
Proposed $20,000
$8,000 $12,000
SB
Value of the Firm
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15-2
The Capital-Structure Question
There are really two important questions: 1. Why should the stockholders care about
15-0
Chapter Outline
15.1 The Capital-Structure Question and The Pie Theory 15.2 Maximizing Firm Value versus Maximizing
Stockholder Interests 15.3 Financial Leverage and Firm Value: An Example 15.4 Modigliani and Miller: Proposition II (No Taxes) 15.5 Taxes 15.6 Summary and Conclusions
EBIT Interest Net income EPS ROA ROE
Recession $1,000 0 $1,000 $2.50 5% 5%
Expected $2,000 0 $2,000 $5.00 10% 10%
Expansion $3,000 0 $3,000 $7.50 15% 15%
Current Shares Outstanding = 400 shares
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Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
15-5
EPS and ROE Under Proposed Capital Structure
EBIT Interest Net income EPS ROA ROE
Recession $1,000 640 $360 $1.50 5% 3%
Expected $2,000 640 $1,360 $5.67 10% 11%
Expansion $3,000 640 $2,360 $9.83 15% 20%
McGraw-Hill/Irwin
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
15-1
The Capital-Structure Question and The Pie Theory
• The value of a firm is defined to be the sum of the value of the firm’s debt and the firm’s equity.
All-Equity Recession
EBIT
$1,000
Interest
0
Net income
$1,000
EPS