Advance Financial Management

If we see the case of all equity e quity if things go better shareholders get a bump up of 8% when moving from 20 to 40 to 60 EBIT. Shareholders get 8% more in your dollar of equity by having a good period. If things do not go well then you earn 8% less on your dollar. The 8% earned is generated only by my dollar of equity and nothing else. Now compared to the company that has half equity and half debt, you invest $1 in equity but along that $1 you borrow a dollar from somebody else and you are responsible for paying that dollar. However you also earned the money that the dollar of debt earns so you are hoping that the $1 of debt earns more more than it costs. By looking a the numbers if times times are good and EBIT from 20 to 40 to 60 then our ROE increases by 16% 16 % however if things do not turn out so well as average then we loss 16%. Therefore we can see that leverage makes good times better and bad times worse. The important thing is to see where does d oes that 16% come from, well 8% comes from what happened to my $1 of equity which is described in the all equity section, therefore my $1 of  equity earned the same thing when it was company A as it did when it was company B just talking about what my own dollar did. Now where did the other 8% came from because we had an 16% bump and the place that it came from is that after tax that dollar percent that I borrowed earned 8% more than it cost. The additional earning on that dollar of o f debt (LEVERAGE SPREAD) took a good time and made it better. We see the same thing if we go from a good period to a bad period, we lose 16%. Where did that come from? Again 8% came from my dollar of equity and my dollar of debt lost the other 8%. Again leverage takes a good time without leverage and makes it better but also takes a bad time without leverage levera ge and makes it worse. Leverage pushes returns to the extremes. The swings +- 8 and +-16 is what we see in the standard deviations, devi ations, if we have twice much risk  the stdev should be twice as much. Stdev is capturing that investors are getting a ride that is twice as rough. We can calculate how much the assets make ROA=40/150=26.7%. Generated a pretax return of  27%. Each dollar whether it was debt or equity generated 27%. It cost me 14% int exp. 12.7% is the pre tax leverage spread (extra return I get on my dollar of debt). It earned 12.7% more than it costs. Then we subtract the tax. The %7.6 is the difference than my m y dollar of equity earned if I invested in company B over company A. By taking on the extra risk I earned and extra 7.6%. That is leverage makes you money you have to get more than the dollar you pay.

Graph debt level against firm value. This is a graph of optimal capital structure. This is a picture of the 4th graph in the video. As we added debt we saw upward pressure on firm value due to the leverage effect the extra spread that shareholders got. A each step shareholders got a spread but the increase in value, the benefit of debt (that spread) is constant as we add dollars of debt each spread is worth 8%. But there is also a corresponding push downward result of increasing a total risk of the firm. The first step is a relative small increase in risk and the start increasing more and more as we add debt. The optimal point is where the risk added is equal to the benefit b enefit (leverage spread) we get from debt. The risk is the down arrows. The extra spread is a good thing thin g but there is going to be

a point where the extra benefit is not worth taking because the risk of that extra spread is going to be too high. 40:13

The reason why bankrupcy risk is increasing is because the number of trouble spots increases, the size of those thouble spots go up and the ability of the firm to pay off those thouble spots also goes down. The 50 and 50 capitalization structure tells us that we give one dollar of our capital and we borrow a dollar from someone else and we have to pay that dolar plus any interest on that dollar however we also get the earings from that dollar. Therefroe it is optimal to borrow when the earnings from that dollar of debt are greater than the cost. When ebit is greater than interest expense. The optimal capital structure is when the leverage spread equals the bankruptcy risk at that point we maximize the value of our firm. After than the risk offsets the benefit from the debt. We are going to lose money. The optimal point is somewhere between 75 and 100 Incremental if the size and time or portion of the cash flows are dependant on my decision whther or not to take the project.