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    Capital Structure - 1

    Uploaded by

    nithyasree1994
    The document illustrates how financial leverage affects earnings per share (EPS) and return on equity (ROE) using the Trans Am Corporation as an example. It shows the current and proposed capital structures, and the EPS and ROE under different economic scenarios. A scroll bar is used to change the debt-equity ratio and demonstrate its impact on the breakeven EBIT and a graph of EPS versus EBIT. Modigliani and Miller Proposition I about the irrelevance of capital structure is also briefly mentioned.

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    © All Rights Reserved
    Download as XLSX, PDF, TXT or read online from Scribd

    Capital Structure - 1

    Uploaded by

    nithyasree1994
    87 views6 pages
    The document illustrates how financial leverage affects earnings per share (EPS) and return on equity (ROE) using the Trans Am Corporation as an example. It shows the current and proposed capital structures, and the EPS and ROE under different economic scenarios. A scroll bar is used to change the debt-equity ratio and demonstrate its impact on the breakeven EBIT and a graph of EPS versus EBIT. Modigliani and Miller Proposition I about the irrelevance of capital structure is also briefly mentioned.

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    Capital Structure_1

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    The document illustrates how financial leverage affects earnings per share (EPS) and return on equity (ROE) using the Trans Am Corporation as an example. It shows the current and proposed capital structures, and the EPS and ROE under different economic scenarios. A scroll bar is used to change the debt-equity ratio and demonstrate its impact on the breakeven EBIT and a graph of EPS versus EBIT. Modigliani and Miller Proposition I about the irrelevance of capital structure is also briefly mentioned.

    Copyright:

    © All Rights Reserved
    Download as XLSX, PDF, TXT or read online from Scribd
    Download as xlsx, pdf, or txt
    87 views6 pages

    Capital Structure - 1

    Uploaded by

    nithyasree1994
    The document illustrates how financial leverage affects earnings per share (EPS) and return on equity (ROE) using the Trans Am Corporation as an example. It shows the current and proposed capital structures, and the EPS and ROE under different economic scenarios. A scroll bar is used to change the debt-equity ratio and demonstrate its impact on the breakeven EBIT and a graph of EPS versus EBIT. Modigliani and Miller Proposition I about the irrelevance of capital structure is also briefly mentioned.

    Copyright:

    © All Rights Reserved
    Download as XLSX, PDF, TXT or read online from Scribd
    Download as xlsx, pdf, or txt
    You are on page 1of 6

    Financial Leverage and Firm Value: An Example

    The capital structure that produces the highest firm value is the capital structure that is most beneficial to sharehold
    illustrate the effects of financial leverage on earnings per share and return on equity using the Trans Am Corporation

    Suppose we have the following current and proposed capital structures for the Trans Am Corporation:

    Current Proposed
    Assets $ 8,000 $ 8,000
    Debt $ - $ 3,556
    Equity $ 8,000 $ 4,444
    Debt-equity ratio 0 0.8
    Share price $ 20 $ 20
    Shares outstanding 400 222
    Interest rate 10% 10%

    With these capital structures, the ROE and EPS for different scenarios will be:

    Current Capital Structure: Debt = $0


    Recession Expected Expansion
    EBIT $ 400 $ 1,200 $ 2,000
    Interest - - -
    Net income $ 400 $ 1,200 $ 2,000
    ROE 5.00% 15.00% 25.00%
    EPS $ 1.00 $ 3.00 $ 5.00

    Proposed Capital Structure: Debt = $3555.55555555556


    Recession Expected Expansion
    EBIT $ 400 $ 1,200 $ 2,000
    Interest 356 356 356
    Net income $ 44 $ 844 $ 1,644
    ROE 1.00% 19.00% 37.00%
    EPS $ 0.20 $ 3.80 $ 7.40

    If we want to examine the effects of leverage for different capital structures, we can simply change the debt-equity r
    debt-equity ratio. If you click one of the arrows on the scroll bar, it changes the pro forma statements for the differen
    below.

    Financial Leverage: EPS and EBIT for Trans Am Corpo


    $10

    $8
    Financial Leverage: EPS and EBIT for Trans Am Corpo
    $10

    $8

    $6
    Earnings per share

    $4

    $2

    $-
    $400 $1,200 $2,0

    Earnings before interest and taxes (no taxes)

    As you can see from changing the debt-equity ratio, the advantages of debt increase as debt increases, but the disad
    ratio increases.

    So what is the breakeven EBIT? We could use Solver or Goal Seek to answer this question if we wanted, but instead w
    us.

    Breakeven EBIT: $ 800.00

    Here is a question for you: How does the breakeven level of EBIT change as the debt-equity ratio changes? Click on t

    Modigliani and Miller Proposition I

    M&M Proposition I states that the total value of a firm's debt and equity will be the same regardless of the firm's cap
    the pie model, which we can graphically examine in Excel. Below, we show an exploded pie chart based on the capit

    Pie Model of Capital Structure

    $3,556
    Debt
    Pie Model of Capital Structure

    $3,556
    Debt
    Equity
    $4,444
    beneficial to shareholders. But, what are the effects of leverage? We can
    Trans Am Corporation as an example.

    Counter: 8 This is the counter for the


    scroll bar.

    ange the debt-equity ratio. In this case, we set up a scroll bar to change the
    ements for the different states of the economy, as well as changes the graph

    Trans Am Corporation
    Trans Am Corporation

    Current Capital Structure


    Proposed Capital Structure

    $2,000

    ncreases, but the disadvantage to debt also increases as the debt-equity

    e wanted, but instead we will create an equation to answer the question for

    tio changes? Click on the scroll bar to find out.

    ardless of the firm's capital structure. This argument has become known as
    art based on the capital structure for the Trans Am Corporation.

    Debt
    Debt
    Equity

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