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16-1 Financial Leverage and Capital Structure Policy Chapter 16 Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin

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16-2 Chapter Outline The Capital Structure Question The Effect of Financial Leverage Capital Structure and EBIT M&M Propositions I and II with Corporate Taxes Bankruptcy Costs

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16-3 Chapter Outline (continued) The Optimal Capital Structure The Pie Again The Pecking-Order Theory Observed Capital Structures A Quick Look at the Bankruptcy Process

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16-4 Chapter Outline The Capital Structure Question The Effect of Financial Leverage Capital Structure and EBIT M&M Propositions I and II with Corporate Taxes Bankruptcy Costs

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16-5 Capital Restructuring Definition: Capital Structure is the amount of debt and the amount of equity a firm uses as its sources of capital.

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16-6 Capital Restructuring Definition: Leverage is the use of financial debt. The concept of leverage is just like that in physics where a small change in one thing has a big effect in another thing.

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16-7 Capital Restructuring We are going to look at how changes in capital structure impact the value of the firm, all else equal. Capital restructuring involves changing the amount of leverage a firm has without changing the firm’s assets.

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16-8 Capital Restructuring The firm can increase leverage by issuing debt and/or repurchasing outstanding shares The firm can decrease leverage by issuing new shares and/or retiring outstanding debt

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16-9 Choosing a Capital Structure What is the primary goal of financial managers? Maximize stockholder wealth! We want to choose the capital structure that will maximize stockholder wealth. We can maximize stockholder wealth by maximizing the value of the firm or minimizing the WACC.

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16-10 Chapter Outline The Capital Structure Question The Effect of Financial Leverage Capital Structure and EBIT M&M Propositions I and II with Corporate Taxes Bankruptcy Costs

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16-11 The Effect of Leverage When we increase the amount of debt financing, we increase the fixed interest expense If we have a really good year, then we pay our fixed cost and we have more left over for our stockholders If we have a really bad year, we still have to pay our fixed costs and we have less left over for our stockholders

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16-12 The Effect of Leverage How does leverage impact the EPS and ROE of a firm? Leverage amplifies the variation in both EPS and ROE. A small change in leverage generates a large change in profits.

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16-13 Example: Financial Leverage, EPS and ROE: Part I (We will ignore the effect of taxes at this stage.) What happens to EPS and ROE when we issue debt and buy back shares of stock?

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16-14 Example: Financial Leverage, EPS and ROE: Part II Variability in ROE Current: ROE ranges from 6% to 20% Proposed: ROE ranges from 2% to 30% Variability in EPS Current: EPS ranges from $0.60 to $2.00 Proposed: EPS ranges from $0.20 to $3.00 The variability in both ROE and EPS increases when financial leverage is increased

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16-15 Chapter Outline The Capital Structure Question The Effect of Financial Leverage Capital Structure and EBIT M&M Propositions I and II with Corporate Taxes Bankruptcy Costs

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16-16 Break-Even EBIT We are trying to find the Earnings Before Interest and Taxes (EBIT) where the Earnings Per Share (EPS) is the same under both the current and proposed capital structures.

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16-17 Break-Even EBIT If we expect the EBIT to be greater than the break-even point, then leverage may be beneficial to our stockholders. If we expect the EBIT to be less than the break- even point, then leverage is detrimental to our stockholders.

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16-18 Example: Break-Even EBIT

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16-19 Example: “Homemade” Leverage and ROE Current Capital Structure Investor borrows $500 and uses $500 of her own to buy 100 shares of stock Payoffs: Recession: 100(0.60) -.1(500) = $10 Expected: 100(1.30) -.1(500) = $80 Expansion: 100(2.00) -.1(500) = $150 Mirrors the payoffs from purchasing 50 shares of the firm under the proposed capital structure Proposed Capital Structure Investor buys $250 worth of stock (25 shares) and $250 worth of bonds paying 10%. Payoffs: Recession: 25(.20) +.1(250) = $30 Expected: 25(1.60) +.1(250) = $65 Expansion: 25(3.00) +.1(250) = $100 Mirrors the payoffs from purchasing 50 shares under the current capital structure

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16-20 Chapter Outline The Capital Structure Question The Effect of Financial Leverage Capital Structure and EBIT M&M Propositions I and II with Corporate Taxes Bankruptcy Costs

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16-21 Capital Structure Theory Modigliani and Miller (M&M) have proposed a two-part “Theory of Capital Structure” Proposition I – Firm value Proposition II – WACC

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16-22 Capital Structure Theory Proposition I – Firm value The value of the firm is determined by the cash flows to the firm and the risk of the assets The firm’s value will change due to: 1. The changing risk of the cash flows 2. The changing cash flows themselves (amounts and timing)

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16-23 Capital Structure Theory Under Three Special Cases No Corporate or personal taxes No bankruptcy costs Case I Corp. taxes; no personal taxes No bankruptcy costs Case II Corp. taxes; no personal taxes Bankruptcy costs Case III

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16-24 Proposition I – Firm Value No Corporate or personal taxes No bankruptcy costs Case I Corp. taxes; no personal taxes No bankruptcy costs Case II Corp. taxes; no personal taxes Bankruptcy costs Case III

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16-25 Proposition I + Case I The value of the firm is NOT affected by changes in the capital structure The cash flows of the firm do not change; therefore, value doesn’t change

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16-26 Prop I + Case I Equations WACC = R A = (E/V)R E + (D/V)R D R E = R A + (R A – R D )(D/E) R A is the “cost” of the firm’s business risk, i.e., the risk of the firm’s assets (R A – R D )(D/E) is the “cost” of the firm’s financial risk, i.e., the additional return required by stockholders to compensate for the risk of leverage

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16-27 Cost of Capital versus D/E Ratios

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16-28 Proposition I + Case I Example 1 Data: Required return on assets = 16% cost of debt = 10% percent of debt = 45% What is the cost of equity? R E = 16 + ( )(.45/.55) = 20.91% R E = R A + (R A – R D )(D/E)

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16-29 Proposition I + Case I Example 2 Data: Required return on assets = 16% cost of debt = 10% percent of debt = 45% Suppose the cost of equity is 25% What is the Debt-to-Equity (D/E) ratio? 25 = 16 + ( ) (D/E) D/E = 1.5 R E = R A + (R A – R D )(D/E)

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16-30 Proposition I – Firm Value No Corporate or personal taxes No bankruptcy costs Case I Corp. taxes; no personal taxes No bankruptcy costs Case II Corp. taxes; no personal taxes Bankruptcy costs Case III

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16-31 Proposition I + Case II Interest is now tax deductible Therefore, when a firm adds debt, it reduces taxes, all else equal The reduction in taxes increases the cash flow of the firm How should an increase in cash flows change the value of the firm?

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16-32 Interest Tax Shield I Annual interest tax shield = Tax rate times interest payment $6,250 in 8% debt = $500 in interest expense Annual tax shield =.34(500) = $170

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16-33 Interest Tax Shield II Present value of annual interest tax shield: Assume perpetual debt for simplicity PV = D(R D )(T C ) / R D PV = $6,250(.08)(.34) /.08 PV = 170 /.08 = $2,125 (But R D (.08) is in both the numerator and the denominator so…) DT C = 6,250(.34) = 2,125

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16-34 Proposition I + Case II The value of the firm increases by the present value of the annual interest tax shield Value of a levered firm = value of an unlevered firm + PV of interest tax shield Value of equity = Value of the firm – Value of debt (Assuming perpetual cash flows) V U = EBIT(1-T) / R U V L = V U + DT C

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16-35 Proposition I + Case II Example 1

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16-36 Proposition I + Case II Example 2 Data: EBIT = $25 million; Tax rate = 35%; Debt = $75 million; Cost of debt = 9%; Unlevered cost of capital = 12% V U = 25(1-.35) /.12 = $ million V L = (.35) = $ million E = – 75 = $86.67 million

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16-37 Firm Value and Taxes

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16-38 Capital Structure Theory Modigliani and Miller (M&M) have proposed a two-part “Theory of Capital Structure” Proposition I – Firm value Proposition II – WACC

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16-39 Capital Structure Theory Proposition II – WACC The Weighted Average Cost of Capital (WACC) of the firm is NOT influenced by the capital structure.

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16-40 Proposition I – Firm Value No Corporate or personal taxes No bankruptcy costs Case I Corp. taxes; no personal taxes No bankruptcy costs Case II Corp. taxes; no personal taxes Bankruptcy costs Case III

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16-41 The CAPM, the SML and Proposition II How does financial leverage change systematic risk? Recall that the CAPM: R A = R f + A (R M – R f ) Where A is the firm’s asset beta and measures the systematic risk of the firm’s assets.

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16-42 The CAPM, the SML and Proposition II How does financial leverage change systematic risk? Proposition II Replace R A with the CAPM and assume that the debt is riskless (R D = R f ) Now, R E = R f + A (1+D/E)(R M – R f )

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16-43 Business Risk and Financial Risk R E = R f + A (1+D/E)(R M – R f ) CAPM: R E = R f + E (R M – R f ) E = A (1 + D/E) Therefore, the systematic risk of the stock depends on: 1.The systematic risk of the assets, A, (Business risk) and 2.The level of leverage, D/E, (Financial risk)

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16-44 M&M Proposition II + Case II The WACC decreases as D/E increases because of the government subsidy on interest payments R E = R U + (R U – R D )(D/E)(1-T C ) R A = (E/V)R E + (D/V)(R D )(1-T C ) Example R E = 12 + (12-9)(75/86.67)(1-.35) = 13.69% R A = (86.67/161.67)(13.69) + (75/161.67)(9)(1-.35) R A = 10.05%

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16-45 M&M Proposition II + Case II R A = (E/V)R E + (D/V)(R D )(1-T C ) R E = R U + (R U – R D )(D/E)(1-T C ) Example: R E = 12 + (12-9)(75/86.67)(1-.35) = 13.69% R A = (86.67/161.67)(13.69) + (75/161.67)(9)(1-.35) R A = 10.05%

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16-46 M&M Proposition II + Case II Example Continued Suppose that the firm changes its capital structure so that the debt-to-equity ratio becomes 1.0 (50% D + 50% E) What will happen to the cost of equity under the new capital structure? R E = 12 + (12 - 9)(1)(1-.35) = 13.95%

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16-47 M&M Proposition II + Case II Example Continued Suppose that the firm changes its capital structure so that the debt-to-equity ratio becomes 1.0 (50% D + 50% E) What will happen to the weighted average cost of capital? R A =.5(13.95) +.5(9)(1-.35) = 9.9%

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16-48 WACC and Leverage

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16-49 Proposition I – Firm Value No Corporate or personal taxes No bankruptcy costs Case I Corp. taxes; no personal taxes No bankruptcy costs Case II Corp. taxes; no personal taxes Bankruptcy costs Case III

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16-50 M&M Proposition II +Case III Now we add bankruptcy costs As the D/E ratio increases, the probability of bankruptcy increases This increased probability will increase the expected bankruptcy costs

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16-51 M&M Proposition II +Case III At some point, the additional value of the interest tax shield will be offset by the increase in expected bankruptcy cost At this point, the value of the firm will start to decrease, and the WACC will start to increase as more debt is added

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16-52 Chapter Outline The Capital Structure Question The Effect of Financial Leverage Capital Structure and EBIT M&M Propositions I and II with Corporate Taxes Bankruptcy Costs

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16-53 Bankruptcy Costs Direct costs: Legal and administrative costs Ultimately cause bondholders to incur additional losses Disincentive to debt financing

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16-54 Bankruptcy Costs Financial distress: Significant problems in meeting debt obligations Firms that experience financial distress do not necessarily file for bankruptcy

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16-55 More Bankruptcy Costs Indirect bankruptcy costs Larger than direct costs, but more difficult to measure and estimate Stockholders want to avoid a formal bankruptcy filing Bondholders want to keep existing assets intact so they can at least receive that money

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16-56 Even More Bankruptcy Costs Indirect bankruptcy costs Assets lose value as management spends time worrying about avoiding bankruptcy instead of running the business The firm may also lose sales, experience interrupted operations and lose valuable employees

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16-57 Optimal Debt to Maximize the Value of the Firm

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16-58 Optimal Capital Structure to Minimize the WACC

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16-59 Chapter Outline (continued) The Optimal Capital Structure The Pie Again The Pecking-Order Theory Observed Capital Structures A Quick Look at the Bankruptcy Process

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16-60 Conclusions: Optimal Capital Structure with M&M No optimal capital structure predicted Case I Optimal capital structure is almost 100% debt Case II Optimal capital structure is part debt and part equity Case III

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16-61 Graphical Presentation of M&M’s Cases I, II, & III

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16-62 Managerial Recommendations The tax benefit is only important if the firm has a large tax liability The risk of financial distress: The greater the risk of financial distress, the less debt will be optimal for the firm The cost of financial distress varies across firms and industries, and as a manager you need to understand the cost for your industry

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16-63 Chapter Outline (continued) The Optimal Capital Structure The Pie Again The Pecking-Order Theory Observed Capital Structures A Quick Look at the Bankruptcy Process

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16-64 Relative Changes in Cash Flow Claims

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16-65 The Value of the Firm Value of the firm = marketed claims + non-marketed claims Marketed claims are the claims of stockholders and bondholders Non-marketed claims are the claims of the government and other potential stakeholders

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16-66 The Value of the Firm The overall value of the firm is unaffected by changes in capital structure. The division of value between marketed claims and non-marketed claims may be impacted by capital structure decisions.

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16-67 Chapter Outline (continued) The Optimal Capital Structure The Pie Again The Pecking-Order Theory Observed Capital Structures A Quick Look at the Bankruptcy Process

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16-68 The Pecking-Order Theory Theory stating that firms prefer to issue debt rather than equity if internal financing is insufficient. Rule 1 Use internal financing first Rule 2 Issue debt next, new equity last

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16-69 The Pecking-Order Theory The pecking-order theory is at odds with the tradeoff theory: There is no target D/E ratio Profitable firms use less debt Companies like financial slack

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16-70 Chapter Outline (continued) The Optimal Capital Structure The Pie Again The Pecking-Order Theory Observed Capital Structures A Quick Look at the Bankruptcy Process

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16-71 Observed Capital Structure The capital structure does differ by major industries: Lowest levels of debt: Computer Industry with 5.61% Drug Industry with 7.25% Highest levels of debt: Cable television industry with % Airline industry with %

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16-72 Chapter Outline (continued) The Optimal Capital Structure The Pie Again The Pecking-Order Theory Observed Capital Structures A Quick Look at the Bankruptcy Process

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16-73 Bankruptcy Process – Part I Business failure – business has terminated with a loss to creditors Legal bankruptcy – petition federal court for bankruptcy Technical insolvency – firm is unable to meet debt obligations Accounting insolvency – book value of equity is negative

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16-74 Bankruptcy Process – Part II Liquidation Chapter 7 of the Federal Bankruptcy Reform Act of 1978 Trustee takes over assets, sells them and distributes the proceeds according to the absolute priority rule

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16-75 Bankruptcy Process – Part II Reorganization Chapter 11 of the Federal Bankruptcy Reform Act of 1978 Restructure the corporation with a provision to repay creditors

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16-76 Work the Web You can find information about a company’s capital structure relative to its industry, sector and the S&P 500 at Reuters Click on the web surfer to go to the site Choose a company and get a quote Choose “Ratio Comparisons”

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16-77 Quick Quiz Explain the effect of leverage on EPS and ROE What is the break-even EBIT, and how do we compute it? How do we determine the optimal capital structure? What is the optimal capital structure in the three cases that were discussed in this chapter? What is the difference between liquidation and reorganization?

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16-78 Comprehensive Problem Assuming perpetual cash flows in Case II - Proposition I, what is the value of the equity for a firm with: EBIT = $50 million Tax rate = 40% Debt = $100 million cost of debt = 9% and unlevered cost of capital = 12%

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16-79 Ethics Issues Suppose managers of a firm know that the company is approaching financial distress. Should the managers borrow from creditors and issue a large one-time dividend to shareholders? How might creditors control this potential transfer of wealth?

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16-80 Terminology Capital Structure Leverage M&M’s Propositions I and II Interest Tax Shield Bankruptcy Optimal Capital Structure

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16-81 Formulas I Value of an Unlevered and Levered Firm: V U = EBIT(1-T) / R U V L = V U + DT C V E = V L - D The Present Value of a Tax Shield Perpetuity : PV = D(R D )(T C ) / R D

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16-82 Formulas II CAPM: R A = R f + A (R M – R f ) If we assume debt is riskless (R D = R f ) then, R E = R f + A (1+D/E)(R M – R f ) If we let A (1+D/E) = E then, the CAPM becomes: R E = R f + E (R M – R f )

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16-83 Formulas III In a world of no corporate taxes: WACC = R A = (E/V)R E + (D/V)R D And the cost of equity (R E ), is: R E = R A + (R A – R D )(D/E) In a world of corporate taxes: R A = (E/V)R E + (D/V)(R D )(1-T C ) R E = R U + (R U – R D )(D/E)(1-T C )

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16-84 Key Concepts and Skills Describe what leverage is. How does leverage change the organization’s cash flow? What is the impact of taxes on leverage? What is the impact of corporate bankruptcy on leverage? How does bankruptcy impact the shareholders?

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Leverage is the use of debt and it can help or hinder the firm’s ROE and EPS. 2. Debt has a tax advantage and as such more debt is better. 3. Debt is risky so there is a maximum debt level to obtain the tax advantage without increasing the WACC. What are the most important topics of this chapter?

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The likelihood of bankruptcy impacts the firm’s WACC. 5. M&M’s theories provide a framework to better understand the relationships of taxes, bankruptcy, firm value and the cost of capital. What are the most important topics of this chapter?

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