BU393 Chapter Notes - Chapter 16: Capital Structure, Arbitrage, Expected Return
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16. 1 the capital structure question and the pie theory. Pie model to demonstrate how firm should choose debt-equity ratio and best capital structure of firm. Value of the firm = b (market value of debt) + s (market value of equity) If (cid:272)o(cid:373)pa(cid:374)(cid:455)"s goal is to (cid:373)ake fi(cid:396)(cid:373) as (cid:448)alua(cid:271)le as possi(cid:271)le, the(cid:374) pi(cid:272)k de(cid:271)t-equity ratio that makes pie (total value) as big as possible. Changes in capital structure benefit shareholders if value of firm increases managers should (cid:272)hoose (cid:272)apital st(cid:396)u(cid:272)tu(cid:396)e (cid:449)ith highest fi(cid:396)(cid:373) (cid:448)alue (cid:271)/(cid:272) (cid:373)ost (cid:271)e(cid:374)efi(cid:272)ial to fi(cid:396)(cid:373)"s sha(cid:396)eholde(cid:396)s. Effe(cid:272)t of fi(cid:374)a(cid:374)(cid:272)ial le(cid:448)e(cid:396)age depe(cid:374)ds o(cid:374) (cid:272)o(cid:373)pa(cid:374)(cid:455)"s earnings before interest. Earnings before interest = expected earnings . Solid line = no debt begins at origin b/c eps = 0 if. Dotted line = debt eps is negative if ebit is 0 b/c firm must pay interest regardless of profits. Dotted line has lower intercept but at higher slope = 2 lines must intersect.
