Jonathan Ray T.

Gonzalo
 Capital Structure
the proportion of debt instruments
and preferred and common stock on
a company’s balance sheet.
a mix of a company’s long-term
debt, specific short-term debt,
common equity and preferred equity
is how a firm finances its overall
operations and growth by using
different sources of funds.
 Assumptions &
Definitions
There are no corporate or personal income taxes
and no bankruptcy costs.
The ratio of debt to equity for a firm is changed
by issuing debt to repurchase stock or issuing
stock to pay off debt.
The firm has a policy of paying 100% of its
earning in dividends. Thus, we abstract from
dividends decision.
The expected values of the subjective
probability distributions of expected future
operating earnings for each company are the
same for all investors in the market.
The operating earnings of the firm are not
expected to grow.
 Given the following assumptions, we are
concerned with the following three rates:
ki = F = Market
Annual interestcharges .
value of debt
B outstanding
In this equation, ki is the yield on the yield on the
company’s debt assuming this debt to be
perpetual.
S Market value of stock outstanding
ke = =
E Earningsavailabletocommonstockholders .

The earnings/price ratio is the required rate of

return for investors in a company whose earnings
are not expected to grow and whose dividend
payout ratio is 100 percent.
ko =VO = Total
NetopeMarket
ratingearningsvalue of the
firm
Where V = B+S. Here is ko is an overall
S
k
capitalization rate for the firm
o = k (
i BB+ ) + B e+ (
k
) S S
 Net Operating Income
Approach
= one approach to the valuation of the earnings
of a company.
Assume that a firm has 1000 in debt at 10
percent interest, that the expected value of
annual net operating earning is 1000 and that
the overall capitalization rates ko is 15 percent.
O Net operating income P
1,000
ko Overall capitalization rate
15
V Total value of firm
E = O-(Ox10%) P6,667
= 1000 – B Market value E of debt
P900
(1000x.10) k =
e S = =
1,000 P5,667
= 1000 – 100 15.88%
S Market value of stock
 ke
2
PERCENTAGE 5
2
0 ko
1
5
1 ki
0
0
LEVERAGE
Capital costs: net operating income
approach
 Traditional Approach
There is an optimal capital structure and that the firm
can increase the total value of the firm through the
judicious use of leverage.
suggests that the firm initially can lower its cost of
capital and raises its total value through leverage.

ke
2
PERCENTAGE

5
2 ko
0
1 ki
5
1
0
0 X
LEVERAGE B/S
MODIGLIANI – MILLER POSITION
Modigliani & Miller = are two economists who
demonstrated that with perfect financial markets
capital structure is irrelevant.
= advocate that the relationship between
leverage and the cost of capital is explained by
the net operating income approach.
They make a formidable attack on the traditional
position by offering behavioral justification for
having the cost of capital , ko remain constant
throughout all degrees of leverage.
= based on the idea that no matter how you
divide up the capital structure of a firm among
debt , equity, and other claims, there is a
conservation of investment value.
1. Capital markets are perfect. Information is costless
and readily available to all investors. There are no
transactions costs, and all securities are infinitely
divisible. Investors are assumed to be rational and to
behave accordingly.

2. The average expected future operating earnings of a

firm are represented by subjective random variables.
It is assumed that the expected values of the
probability distribution of all investors are the same.
The MM illustration implies that the expected values
of the probability distributions of
3. Firms can be categorized into “equivalent
return” classes. All firms within a class
have the same degree of business risk.

4. The absence of corporate income taxes

is assumed.
 Homemade Leverage
can replicate the firm’s capital structure, thereby causing investors
to be in different to it.

Debt Debt
Equit Equit
y y

FIRM
FIRM VALUE
VALUE
Company A Company B
O Net operating income 10,000 10,000
F Interest on debt 3,600
E Earning available to
common stockholders 10,000 6,400

ke Required equity return 15 16

S Market value of stock66,667 40,000

B Market value of debt 30,000
V Total value of firm 66,667 70,000

k Implied overall capitalization rate 15% 14.3%

B/S Debt-to-equity ratio 0 75%
MM maintain that this situation cannot continue, for
arbitrage will drive the total values of the two firms
together. Company B command a higher total value
simply because it has a financing mix different from
Company A’s MM argue that by investing in company
A, investors in company B are able to obtain the same
dollar return with no increase in financial risk.
Moreover they are able to do so with a smaller
investment outlay. Because investors would be better
off with the investment requiring the lesser outlay,
they would sell their shares inn company B and buy
shares in company A. These arbitrage transactions
would continue until company B’s shares declined in
price and company A ‘s shares increase in price
enough to make the total value of the two firms
identical.
Arbitrage Steps If you are rational investor who
owns 1 percent of the stock of company B, the
levered firm, worth $400 (market value) you
should
1.Sell the stock in company B for $400
2.Borrow $300 at 12 percent interest. This personal
debt is equal to 1 percent of the debt of company
B, your previous proportional ownership of the
company.
3.Buy 1 percent of the shares of company A, the
unlevered firm, for $666.67

Prior to this series of transactions, your expected

return on investment in company B’s stock was 16
percent on a $400 investment or $64. Your
expected return on investment in company A is
15% on a $666.67 investment, or $100.
Return on investment in company A $100
Less: interest ($300 x .12) 36
Net return $ 64
________________________________________________
Your net return , 64, is the same as it was for your investment
in company B; however, your cash outlay of 366.67(666.67 less
personal borrowings of 300) is less that the 400 investment in
company B, the levered firm. Because of the lover investment,
you would prefer to invest in company A under the conditions
described. In essence, you “lever” the stock of the unlevered
firm by taking on personal debt.
ARBITRAGE EFFICIENCY = All opportunities for arbitrage profit
have been driven out.
CORPORATE TAXES = create an incentive for debt
through the deduction of interest as an expense.
One of the most important imperfections is the
presence d is the presence of taxes. In this regard, we
examine the valuation impact of corpo0rate taxes in
the absence of personal taxes and then the combined
effect of corporate and personal taxes.
They elude taxation at the corporate level whereas
dividends or retained earnings associated with stock
are not deductable by the corporation for tax
purposes. Consequently, the total amount of
payments available for both debt holders and stock
holders if debt is employed.
 To illustrate , suppose the earnings before interest and taxes
are 2,000 for companies X and Y, and they are alike in every
respect except in leverage. Company Y has 5,000 in debt at
12 % interest, whereas company X has no debt. If the tax rate
(federal and state) is 40% for each company we have
Company X Company Y
Earnings before interest and taxes 2,000 2,000
Interest, income to debt holders 0 600
Profit before taxes 2,000 1,400
Taxes 800 540
Income available to stock holders 1,200 840
Income to debt holders plus income
to stockholders 1,200 1,440
Thus total income to both debt holders and stock
holders is larger for levered company Y than it is
for unlevered company X. The reason is that
debt holders received interest payments without
the deduction of taxes at the corporate level,
whereas income to stockholders is after
corporate taxes have been paid. In essence, the
government pays a subsidy to the levered
company for the use of debt. Total income to all
investors increases by the interest payment
times the tax rate.(600 x .40 = 240). This figure
represents a tax shield that the government
provides the levered company. If the debt
employed by a company is permanent, the
present value of the tax shield using perpetuity
formula is: tcrB
Present value of tax shield=
r
=tcB
MILLER’S EQUILIBRIUM = has the personal tax
effect entirely offsetting the corporate tax
advantage
BANKRUPTCY COST = are a dead weight loss to
suppliers of capital
IMPERFECTIONS = causes interior no extreme
solutions to the capital structure issue.
AGENCY COST = arise when different stakeholders
monitor each other’s behavior.
OPTION PRICE = portrayal of debt versus equity is
a zero-sum game
UNDERINVESTMENT = is the result of equity
holders not wishing to invest when the rewards
favor debt holders.
CREDIBILITY of a financial signal depends on
asymmetric information.
 Sample Questions
1. Siony Company and Doom Calculators, Inc. are identical
except for capital structures. Siony has 50% debt and 50%
equity, whereas, Doom has 20% debt and 80% equity. (all
percentages are in market-value terms.) The borrowing rate
for both companies is 8% in a non-tax world, and capital
markets are assumed to be perfect.
a.) (1) if you own 2% of the stock of Siony, what is your dollar
return if the company has net operating income of 360,000
and the overall capitalization rate of the company ko is 18%?
(2) What is the implied required rate of return on equity?
b.) Doom has the same net operating income as Siony. (1.)
What is the implied required equity return of Doom? (2.)
Why does it differ from that of Siony
 Answers
1.
a.(1)
Net Operating Income 360,000
Overall capitalization rate .18
Total value of firm 2,000,000
Market value of debt (50%) 1,000,000
Market value of stock (50%)1,000,000

Net Operating income 360,000

Interest on debt (8%) 80,000
Earning to common 280,000

2% of 280,000 = 5,600
(2) Implied required equity return =
280,000/1,000,000
= 28%
 Answers
b. (1)
Total value of firm 2,000,000
Market value of debt (20%) 400,000
Market value of Equity (80%) 1,600,000

Net Operating income 360,000

Interest on debt (8%) 32,000
Earnings to common 328,000

Implied required equity return = 328,000/1,600,000 = 20.5%

(2) It is lower because Doom uses less debt in its capital
structure . As the equity capitalization is a linear function
of the debt-to-equity ratio when we use the net operating
income approach, the decline in required equity return
offsets exactly the disadvantage of not employing so much
in the way of cheaper debt funds.