© K. Cuthbertson and D. Nitzsche Figures for Chapter 11 VALUING FIRMS : CAPITAL STRUCTURE AND THE COST OF CAPITAL (Investments : Spot and Derivatives Markets)

© K. Cuthbertson and D. Nitzsche Figure 11.1 : Traditional view : cost of capital Cost of capital Debt-to equity ratio (B/S) Equity, R S WACC Debt, R b (B/S)*

© K. Cuthbertson and D. Nitzsche Figure 11.2 : How leverage affects equity returns Equity return, R S Earnings, Y i As earnings Y i change from 1m to 4m, the equity return R S for the all equity financed firm moves from 10% to 40% (A to B) but for the 50% levered firm the equity return changes much more, from 10% to 70% (A’ to C). 10% 20% 30% 40% 70% 1m4m0.5m C A’ B A 50% equity (50% debt) 100% equity (0% debt)

© K. Cuthbertson and D. Nitzsche Figure 11.3 : Value of the firm : MM proposition I (no taxes) Value of firm, V Debt-to equity ratio (B/S) V V is independent of B/S

© K. Cuthbertson and D. Nitzsche Figure 11.4 : The cost of equity finance : MM proposition II (no taxes) Cost of capital Debt-to equity ratio (B/S) WACC, R w RbRb (B/S)* R S = R w + (R w -R b ) (B/S) Debtholders share some of the business risk Cost of equity rises with rising debt-to-equity ratio

© K. Cuthbertson and D. Nitzsche Figure 11.5 : Value of the firm : MM proposition I (no taxes and bankruptcy) Value of firm, V Debt-to equity ratio (B/S) MM no taxes Optimal debt-to equity-ratio MM with corporate taxes only MM with corporate taxes and bankruptcy costs