Capital Structure Policy Essay

265 WordsFeb 27, 20122 Pages
Capital Structure Policy (Trans Can Corporation): Homemade Leverage Firm’s Capital Structure: Assume net operating income of $1,000,000, no debt, and 400,000 shares outstanding valued at $20 each. The firm (like individuals) can borrow money and pay a 10% interest rate. There are no transaction costs or taxes. Currently the shareholders earn a ROI of: $1,000,000/(400,000 x $20) = 12.5% Let’s say that the firm wants to have a D/E ratio of 1.0 and has decided to incur $4,000,000 in debt at 10%. It will use this borrowed money to buy back 200,000 shares at $20 each. What is the new ROI? ($1,000,000 - $4,000,000 x 10%)/(200,000 x $20) = 15% Creating Homemade Leverage: An investor who owns shares in the firm with no debt, can create homemade leverage by borrowing themselves and replicating the desired D/E structure they wish the firm to have. How? If the company remains unlevered, as above, the shareholders earn a ROI of: $1,000,000/(400,000 x $20) = 12.5% The individual investor who desires a D/E structure of 1.0 would (for example) buy 4,000 shares, 1% ownership in the firm, for $80,000 by paying cash of $40,000 and borrowing $40,000 at 10%. This investor would earn a ROI in the unlevered firm using homemade leverage of: ($1,000,000 x 1% - $40,000 x 10%)/$40,000 = 15% Note: To undo homemade leverage, investors must lend money at the cost of

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