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Chapter 15
Capital Structure Decisions
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Topics in Chapter Overview and preview of capital
structure eects Business versus nancial riskThe impact of det on returns Capital structure theor!" evidence"
and implications for mana#ers $%ample& Choosin# the optimal
structure
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Value = + + +FCF1 FCF2 FCF
(1 + WACC)1 (1 +WACC)
(1 + WACC)2
Free cash fow(FCF)
Market interest rates
Firms !usiness riskMarket risk a"ersion
Firms
#e!t$e%uit&mi'
Cost o #e!t
Cost o e%uit&
Weihte# a"erae
cost o ca*ital(WACC)
et o*eratin*ro,t ater ta'es
-e%uire# in"estmentsin o*eratin ca*ital
.
=
/eterminants o 0ntrinsic Valuehe Ca*ital 3tructure Choice
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Basic Denitions ) * value of rm
+C+ * free cash ,ow
-.CC * wei#hted avera#e cost ofcapital
rsand rd are costs of stock and det
wsand wdare percenta#es of the rm
that are nanced with stock and det/
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0ow can capital structure
aect value
) * 3
t*
1
+C+t
41
-.CC6t
-.CC* wd417T6 rd wsrs
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. 9review of Capital
Structure $ectsThe impact of capital structure on
value depends upon the eect of
det on& -.CC
+C+
(Continued)
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The $ect of .dditional
Det on -.CC Detholders have a prior claim on cash
,ows relative to stockholders/
Detholders; educes after7ta% cost of det
(Continued)
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The $ect on -.CC
4Continued6 Det increases risk of ankruptc!
Causes pre7ta% cost of det" rd" to
increase .ddin# det increase percent of rm
nanced with low7cost det 4wd6 and
decreases percent nanced withhi#h7cost e@uit! 4ws6
Aet eect on -.CC * uncertain/(Continued)
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The $ect of .dditional
Det on +C+ .dditional det increases the
proailit! of ankruptc!/ Direct costs& e#al fees"
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mpact of indirect costs AO9.T #oes down due to lost
customers and drop in productivit! nvestment in capital #oes up due to
increase in net operatin# workin#
capital 4accounts pa!ale #oes downas suppliers ti#hten credit6/
(Continued)
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.dditional det can aect the ehaviorof mana#ers/
>eductions in a#enc! costs& det
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.s!mmetric nformation
and Si#nalin# Gana#ers know the rm;s future
prospects etter than investors/
Gana#ers would not issue additionale@uit! if the! thou#ht the current stockprice was less than the true value of thestock 4#iven their inside information6/
0ence" investors often perceive anadditional issuance of stock as ane#ative si#nal" and the stock price falls/
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Business >isk& Hncertaint!
in $BT" AO9.T" and >OC Hncertaint! aout demand 4unit
sales6/
Hncertaint! aout output prices/
Hncertaint! aout input costs/
9roduct and other t!pes of liailit!/
De#ree of operatin# levera#e4DO6/
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-hat is operatin# levera#e" andhow does it aect a rm;s
usiness risk Operatin# levera#e is the chan#e
in $BT caused ! a chan#e in
@uantit! sold/The hi#her the proportion of %ed
costs relative to variale costs" the
#reater the operatin# levera#e/
(More...)
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0i#her operatin# levera#e leads tomore usiness risk& small sales
decline causes a lar#er $BT decline/
(More...)
Sales
$ Rev.
TC
FQBE
EBIT}$
Rev.
TC
F
QBESales
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Operatin# Breakeven I is @uantit! sold" + is %ed cost" ) is
variale cost" TC is total cost" and 9 is
price per unit/ Operatin# reakeven * IB$ IB$* + J 49 K )6
$%ample& +*L2EE" 9*L15" and )*L1E& IB$* L2EE J 4L15 K L1E6 * (E/
(More...)
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Business >isk versus+inancial >isk
Business risk& Hncertaint! in future $BT" AO9.T" and >OC/
Depends on usiness factors such ascompetition" operatin# levera#e" etc/
+inancial risk& .dditional usiness risk concentrated on
common stockholders when nancial levera#eis used/
Depends on the amount of det and preferredstock nancin#/
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Consider Two 0!pothetical+irms dentical $%cept for
Det+irm H +irm
Capital L2E"EEE L2E"EEE
Det LE L1E"EEE 412Mrate6
$@uit! L2E"EEE L1E"EEETa% rate (EM (EM
$BT L'"EEE L'"EEEAO9.T L1"?EE L1"?EE>OC M M
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mpact of evera#e on>eturns
+irm H +irm
$BT L'"EEE L'"EEE
nterest E 1"2EE$BT L'"EEE L1"?EE
Ta%es 4(EM6 1 "2EE :2EA L1"?EE L1"E?E
>OC /EM /EM>O$4AJ$@uit!6
/EM 1E/?M
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-h! does levera#in#increase return
Gore cash #oes to investors of +irm /Total dollars paid to investors&
H& A * L1"?EE/ & A nt * L1"E?E L1"2EE * L2"2?E/
Ta%es paid& H& L1"2EE
& L:2E/ n +irm " fewer dollars are tied up in
e@uit!/
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mpact of evera#e on>eturns if $BT +alls
+irm H +irm
$BT L2"EEE L2"EEE
nterest E 1"2EE
$BT L2"EEE L?EE
Ta%es 4(EM6 ?EE '2EA L1"2EE L(?E
>OC 8/EM 8/EM
>O$ 8/EM (/?M
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Capital Structure Theor!
GG theor! ero ta%es Corporate ta%es Corporate and personal ta%es
Trade7o theor! Si#nalin# theor!
9eckin# order Det nancin# as a mana#erial constraint -indows of opportunit!
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GG Theor!& ero Ta%es
+irm H +irm
$BT L'"EEE L'"EEE
nterest E 1"2EE
A L'"EEE L1"?EE
C+ toshareholder
L'"EEE L1"?EE
C+ todetholder
E L1"2EE
Total C+ L'"EEE L'"EEE
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GG >esults& ero Ta%es
GG assume& 416 no transactions costsP 426 norestrictions or costs to short salesP and 4'6individuals can orrow at the same rate as
corporations/ GG prove that if the total C+ to investors of +irm
H and +irm are e@ual" then aritra#e is possileunless the total values of +irm H and +irm aree@ual&
)* )H/ Because +C+ and values of rms and H are
e@ual" their -.CCs are e@ual/ Therefore" capital structure is irrelevant/
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GG Theor!& CorporateTa%es
Corporate ta% laws allow interest toe deducted" which reduces ta%espaid ! levered rms/
Therefore" more C+ #oes toinvestors and less to ta%es whenlevera#e is used/
n other words" the det
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GG >esult& CorporateTa%es
GG show that the total C+ to +irm ;sinvestors is e@ual to the total C+ to +irm
H;s investor plus an additional amount dueto interest deductiilit!& C+* C+H rdDT/
-hat is value of these cash ,ows )alue of C+H* )H GG show that the value of rdDT * TD Therefore" )* )H TD/
f T*(EM" then ever! dollar of det adds(E cents of e%tra value to rm/
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Value of Firm, V
0 Deb
V!
V"
"#er MM %i& 'ororae aes, &e firm*s valuei#'reases 'o#i#uousl+ as more a# more eb is use.
TD
GG relationship etween value anddet when corporate ta%es are
considered/
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Giller;s Theor!& Corporateand 9ersonal Ta%es
9ersonal ta%es lessen the advanta#eof corporate det& Corporate ta%es favor det nancin#
since corporations can deduct intereste%penses/
9ersonal ta%es favor e@uit! nancin#"since no #ain is reported until stock issold" and lon#7term #ains are ta%ed ata lower rate/
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Giller;s Godel withCorporate and 9ersonal
Ta%es
)* )H 1Q D
Tc* corporate ta% rate/
Td* personal ta% rate on detincome/
Ts* personal ta% rate on stock
income/
(1 - Tc)(1 - Ts)
(1 - Td)
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Tc* (EM" Td* 'EM"
and Ts* 12M/
)
* )H
1Q D
* )H 41 7 E/:56D
* )H
E/25D/
)alue rises with detP each L1 increasein det raises ;s value ! LE/25/
(1 - 0.40)(1 - 0.12)
(1 - 0.30)
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Conclusions with 9ersonalTa%es
Hse of det nancin# remainsadvanta#eous" ut enets are less
than under onl! corporate ta%es/ +irms should still use 1EEM det/ Aote& 0owever" Giller ar#ued that in
e@uilirium" the ta% rates ofmar#inal investors would adFust untilthere was no advanta#e to det/
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Trade7o Theor!
GG theor! i#nores ankruptc! 4nancialdistress6 costs" which increase as morelevera#e is used/
.t low levera#e levels" ta% enetsoutwei#h ankruptc! costs/
.t hi#h levels" ankruptc! costs
outwei#h ta% enets/ .n optimal capital structure e%ists that
alances these costs and enets/
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Ta% Shield vs/ Cost of +inancialDistress
Value of Firm, V
0 Deb
V!
V"
Ta S&iel
Disress Coss
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Si#nalin# Theor!
GG assumed that investors andmana#ers have the same information/
But" mana#ers often have etterinformation/ Thus" the! would& Sell stock if stock is overvalued/ Sell onds if stock is undervalued/
nvestors understand this" so view newstock sales as a ne#ative si#nal/
mplications for mana#ers
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9eckin# Order Theor!
+irms use internall! #enerated fundsrst" ecause there are no ,otation
costs or ne#ative si#nals/ f more funds are needed" rms then
issue det ecause it has lower ,otationcosts than e@uit! and not ne#ative
si#nals/ f more funds are needed" rms then
issue e@uit!/
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Det +inancin# and.#enc! Costs
One a#enc! prolem is thatmana#ers can use corporate funds
for non7value ma%imiRin# purposes/The use of nancial levera#e&
Bonds
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. second a#enc! prolem is thepotential for
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nvestment Opportunit! Setand >eserve Borrowin#
Capacit! +irms with man! investment
opportunities should maintain
reserve orrowin# capacit!"especiall! if the! have prolemswith as!mmetric information
4which would cause e@uit! issuesto e costl!6/
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-indows of Opportunit!
Gana#ers tr! to
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$mpirical $vidence
Ta% enets are importantK L1 detadds aout LE/1E to value/
Bankruptcies are costl!K costs cane up to 1EM to 2EM of rm value/
+irms don;t make @uick corrections
when stock price chan#es causetheir det ratios to chan#eK doesn;tsupport trade7o model/
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$mpirical $vidence4Continued6
.fter i# stock price run ups" det ratiofalls" ut rms tend to issue e@uit!instead of det/ nconsistent with trade7o model/ nconsistent with peckin# order/ Consistent with windows of opportunit!/
Gan! rms" especiall! those with #rowthoptions and as!mmetric informationprolems" tend to maintain e%cessorrowin# capacit!/
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mplications for Gana#ers
Take advanta#e of ta% enets !issuin# det" especiall! if the rm
has& 0i#h ta% rate
Stale sales
ow operatin# levera#e
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mplications for Gana#ers4Continued6
.void nancial distress costs !maintainin# e%cess orrowin#
capacit!" especiall! if the rm has& )olatile sales 0i#h operatin# levera#e Gan! potential investment opportunities
Special purpose assets 4instead of #eneralpurpose assets that make #ood collateral6
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((
mplications for Gana#ers4Continued6
f mana#er has as!mmetricinformation re#ardin# rm;s future
prospects" then avoid issuin# e@uit!if actual prospects are etter thanthe market perceives/
.lwa!s consider the impact ofcapital structure choices on lenders;and ratin# a#encies; attitudes
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Choosin# the OptimalCapital Structure& $%ample
* 1/EP r>+* 8MP >9G* 8M/
Cost of e@uit! usin# C.9G& rs* r>+ 4>9G6* 8M 148M6 * 12M
Currentl! has no det& wd* EM/ -.CC * rs* 12M/
Ta% rate is T * (EM/
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Current )alue ofOperations
$%pected +C+ * L'E million/
+irm e%pects Rero #rowth& # * E/
)op* +C+41#6J4-.CC #6
)op* L'E41E6J4E/12 0)
)op* L25E million/
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Other Data for )aluation.nal!sis
Compan! has no ST investments/
Compan! has no preferred stock/
1EE"EEE shares outstandin#
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Current )aluation .nal!sis
)op L25E
ST nv/ E
)Total L25E
Q Det E
S L25E
Un 1E
9 L25/EE
t t k id d
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nvestment ankers providedestimates of rdfor dierent capital
structures/w# 45 245 645 745 845
r# E/EM ?/EM ?/5M 1E/EM 12/EM
f compan! recapitaliRes" it will use proceedsfrom det issuance to repurchase stock/
Th C t f $ it t Di t
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The Cost of $@uit! at Dierentevels of Det& 0amada;s
+ormula GG theor! implies that eta
chan#es with levera#e/
His the eta of a rm when it hasno det 4the unlevered eta6
* H1 41 7 T64wdJws6
Th C f $ i f
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The Cost of $@uit! for wd*
2EM
Hse 0amada;s e@uation to nd eta&
* H1 41 7 T64wdJws6 * 1/E 1 417E/(6 42EM J ?EM6
* 1/15
Hse C.9G to nd the cost of e@uit!&
rs* r>+ C 4>9G6
* 8M 1/15 48M6 * 12/M
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The -.CC for wd* 2EM
-.CC * wd417T6 rd wcers -.CC * E/2 41 K E/(6 4?M6 E/?
412/M6 -.CC * 11/2?M
>epeat this for all capitalstructures under consideration/
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Beta" rs" and -.CC
w# 45 245 645 745 845
r# E/EM ?/EM ?/5M 1E/EM 12/EM
ws 1EEM ?EM :EM 8EM 5EM
! 1/EEE 1/15E 1/25: 1/(EE 1/8EE
rs 12/EEM 12/EM 1'/5(M 1(/(EM 15/8EM
WACC 12/EEM 11/2?M 119415 11/E(M 11/(EM
he WACC is minimi:e# or w#= 6459 his is the
o*timal ca*ital structure9
C t ) l f
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Corporate )alue for wd*
2EM
)op* +C+41#6J4-.CC #6
)op* L'E41E6J4E/112? 0)
)op* L285/8 million/ Det * DAew* wd)op
Det * E/2E4285/86 * L5'/1 million/
$@uit! * S * ws)op
$@uit!* E/?E4285/86 * L212/:: million/
) l f O i D
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)alue of Operations" Det"and $@uit!
w# 45 245 645 745 845
r# E/EM ?/EM ?/5M 1E/EM 12/EM
ws 1EEM ?EM :EM 8EM 5EM
! 1/EEE 1/15E 1/25: 1/(EE 1/8EE
rs 12/EEM 12/EM 1'/5(M 1(/(EM 15/8EM
WACC 12/EEM 11/2?M 11/E1M 11/E(M 11/(EM
Vo* L25E/EE L285/8 ;2
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.natom! of a >ecap&Before ssuin# Det
Before Det
)op L25E
ST nv/ E
)Total L25E
Q Det E
S L25E
Un 1E9 L25/EE
Totalshareholder
wealth& S
D t 4 2EM6
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ssue Det 4wd* 2EM6"
But Before >epurchase
-.CC decreases to 11/2?M/
)opincreases to L285/5:(/
+irm temporaril! has short7terminvestments of L5'/115 4until ituses these funds to repurchase
stock6/ Det is now L5'/115/
. t f > .ft
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.natom! of a >ecap& .fterDet" ut Before>epurchase
Before Det.fter Det"
Before >ep/
)op L25E L285/8
ST nv/ E 5'/1
)Total L25E L'1/15
Q Det E 5'/1
S L25E L285/8
Un 1E 1E
9 L25/EE L28/8E
Total
shareholder
.ft i D t B f
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.fter ssuin# Det" Before>epurchasin# Stock
Stock price increases from L25/EEto L28/8E/
-ealth of shareholders 4due toownership of e@uit!6 increasesfrom L25E million to L285/8
million/
Th > h A $ t
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The >epurchase& Ao $ecton Stock 9rice
The announcement of an intended repurchasemi#ht send a si#nal that aects stock price"and the previous chan#e in capital structure
aects stock price" ut the repurchase itselfhas no impact on stock price/ f investors thou#ht that the repurchase would
increase the stock price" the! would all purchasestock the da! efore" which would drive up its price/
f investors thou#ht that the repurchase woulddecrease the stock price" the! would all sell short thestock the da! efore" which would drive down thestock price/
> i i A f
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>emainin# Aumer ofShares .fter >epurchase
DOldis amount of det the rm initiall! has"DAewis amount after issuin# new det/
f all new det is used to repurchase
shares" then total dollars used e@uals 4DAewK DOld6 * 4L5'/1 7 LE6 * L5'/1/
n9rioris numer of shares eforerepurchase" n9ostis numer after/ Total
shares remainin#& n9ost* n9riorK 4DAewK DOld6J9n9ost* 1E K 4L5'/1JL28/8E6
n9ost* ? million/
4#nore roundin# dierencesP see Ch15 Mini Case.xlsfor actual calculations6/
. t f > .ft
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.natom! of a >ecap& .fter>upurchase
Before Det.fter Det"
Before >ep/ .fter >ep/
)op L25E L285/8 L285/8
ST nv/ E 5'/1 E
)Total L25E L'1/15 L285/8
Q Det E 5'/1 5'/1
S L25E L285/8 L212/::
Un 1E 1E ?
9 L25/EE L28/8E L28/8E
Total
shareholder
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We! 9oints
ST investments fall ecause the! areused to repurchase stock/
Stock price is unchan#ed/ )alue of e@uit! falls from L285/8 to
L212/:: ecause rm no lon#er ownsthe ST investments/
-ealth of shareholders remains at
L285/8 ecause shareholders nowdirectl! own the funds that were held !rm in ST investments/
ntrinsic Stock 9rice
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ntrinsic Stock 9riceGa%imiRed at OptimalCapital Structurew# 45 245 645 745 845
r# E/EM ?/EM ?/5M 1E/EM 12/EM
ws 1EEM ?EM :EM 8EM 5EM
! 1/EEE 1/15E 1/25: 1/(EE 1/8EE
rs 12/EEM 12/EM 1'/5(M 1(/(EM 15/8EM
WACC 12/EEM 11/2?M 119415 11/E(M 11/(EM
Vo* L25E/EE L285/8 ;2
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Shortcuts
The corporate valuation approachwill alwa!s #ive the correct
answer" ut there are someshortcuts for ndin# S" 9" and n/
Shortcuts on ne%t slides/
Calculatin# S the )alue of
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Calculatin# S" the )alue of$@uit! after the >ecap
S * 41 K wd6 )op .t wd* 2EM&
S * 41 K E/2E6 L285/8
S * L212/::/
4#nore roundin# dierencesP see Ch15 Mini Case.xlsfor actual calculations6/
Aumer of Shares after a
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Aumer of Shares after a>epurchase" n9ost
.t wd* 2EM&
n9ost* n9rior4)opAewDAew6J4)opAewDOld6
n9ost* 1E4L285/8 L5'/16J4L285/8 LE6
n9ost* ?
Calculatin# 99ost the
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Calculatin# 99ost" theStock 9rice after a >ecap
.t wd* 2EM&
99ost* 4)opAewDOld6Jn9rior
n9ost* 4L285/8 LE6J1E
n9ost* L28/8E
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Optimal Capital Structure
wd* 'EM #ives&
0i#hest corporate value owest -.CC
0i#hest stock price per share
But wd* (EM is close/ Optimal ran#eis prett! ,at/
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