Financial Leverage and Firm Value: An Example

The capital structure that produces the highest firm value is the capital structure that is most beneficial to sharehold
illustrate the effects of financial leverage on earnings per share and return on equity using the Trans Am Corporation

Suppose we have the following current and proposed capital structures for the Trans Am Corporation:

Current Proposed
Assets $ 8,000 $ 8,000
Debt $ - $ 3,556
Equity $ 8,000 $ 4,444
Debt-equity ratio 0 0.8
Share price $ 20 $ 20
Shares outstanding 400 222
Interest rate 10% 10%

With these capital structures, the ROE and EPS for different scenarios will be:

Current Capital Structure: Debt = $0

Recession Expected Expansion
EBIT $ 400 $ 1,200 $ 2,000
Interest - - -
Net income $ 400 $ 1,200 $ 2,000
ROE 5.00% 15.00% 25.00%
EPS $ 1.00 $ 3.00 $ 5.00

Proposed Capital Structure: Debt = $3555.55555555556

Recession Expected Expansion
EBIT $ 400 $ 1,200 $ 2,000
Interest 356 356 356
Net income $ 44 $ 844 $ 1,644
ROE 1.00% 19.00% 37.00%
EPS $ 0.20 $ 3.80 $ 7.40

If we want to examine the effects of leverage for different capital structures, we can simply change the debt-equity r
debt-equity ratio. If you click one of the arrows on the scroll bar, it changes the pro forma statements for the differen
below.

Financial Leverage: EPS and EBIT for Trans Am Corpo

$10

$8
 Financial Leverage: EPS and EBIT for Trans Am Corpo
$10

$8

$6
Earnings per share

$4

$2

$-
$400 $1,200 $2,0

Earnings before interest and taxes (no taxes)

As you can see from changing the debt-equity ratio, the advantages of debt increase as debt increases, but the disad
ratio increases.

So what is the breakeven EBIT? We could use Solver or Goal Seek to answer this question if we wanted, but instead w
us.

Breakeven EBIT: $ 800.00

Here is a question for you: How does the breakeven level of EBIT change as the debt-equity ratio changes? Click on t

Modigliani and Miller Proposition I

M&M Proposition I states that the total value of a firm's debt and equity will be the same regardless of the firm's cap
the pie model, which we can graphically examine in Excel. Below, we show an exploded pie chart based on the capit

Pie Model of Capital Structure

$3,556
Debt
 Pie Model of Capital Structure

$3,556
Debt
Equity
$4,444
beneficial to shareholders. But, what are the effects of leverage? We can
Trans Am Corporation as an example.

Counter: 8 This is the counter for the

scroll bar.

ange the debt-equity ratio. In this case, we set up a scroll bar to change the
ements for the different states of the economy, as well as changes the graph

Trans Am Corporation
Trans Am Corporation

Current Capital Structure

Proposed Capital Structure

$2,000

ncreases, but the disadvantage to debt also increases as the debt-equity

e wanted, but instead we will create an equation to answer the question for

tio changes? Click on the scroll bar to find out.

ardless of the firm's capital structure. This argument has become known as
art based on the capital structure for the Trans Am Corporation.

Debt
Debt
Equity