Market Essay

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CHAPTER 6 – The Financing Decision * Financial Leverage: Using Debt * 2 Step Process: selecting proper financing instruments 1. Decide how much external capital is required 2. Select the instrument to be sold a. Heart of the financing decision b. Bonds or Stocks? OPM (Financial Leverage)- Other People’s Money – a device to increase owners’ expected return at the cost of greater risk (increases owners’ risk/return, wide range of possibilities) – replacing owners’ equity with fixed-cost debt * Equity financing: between -5% and 20% return * Debt financing: between -45% and 80% return Operating Leverage - Rplacing variable-cost methods with fixed-cost methods (replacing hourly workers with robots) * 2 Effects of Increased Financial Leverage 1. More operating income is required to cover the fixed-costs 2. Once breakeven point is reached, profits grow more quickly with operating income Return on Equity- widely used measure of financial performance ROE = ROIC + (ROIC – i’) D/E [%+(%-%)*$/$] * ROIC: Return on Invested Capital [EBIT after tax/all sources of cash on which a return must be earned] * i’: after-tax interest rate[ (1-t)*i] * D: interest-bearing debt * E: book value of equity * Other descriptions/formulas footnote on page 207 *When a company earns more on borrowed money than it pays in interest, return on equity will rise; vise versa. Leverage improves performance when things are going well and worsens performance when things are going poorly. * Measuring the Effects of Leverage on a Business * Leverage and Risk * Can the company safely carry the financial burden imposed by new debt? * Compare the company’s forecasted operating cash flows to the annual financial burden imposed by debt * Construct pro forma financial

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