Chap 016

Randolph W.
Westerfield
Jeffrey Jaffe
Ram Kumar Kakani
CORPORAT
E FINANCE
Copyright 2014 by McGraw Hill Education (India) Private Limited. All rights reserved.
Stephen A. Ross
10/E
16-1
Capital Structure: Basic Concepts
Chapter
16
16-2
(i.e., capital structure) on firm earnings

Understand homemade leverage
Understand capital structure theories with
and without taxes
Understand the effect of financial leverage
Be able to compute the value of the
unlevered and levered firm

16-3
16.2 Maximizing Firm Value versus Maximizing

Stockholder Interests
16.3 Financial Leverage and Firm Value: An
Example
16.4 Modigliani and Miller: Proposition II (No
Taxes)
16.1 The Capital Structure Question and The Pie

Theory
16.5 Taxes
16-4
value of the firms debt and the firms equity.
V=B+S
If the goal of the firms
management is to make
the firm as valuable as
possible, then the firm
should pick the debtequity ratio that makes the
pie as big as possible.
S B
The value of a firm is defined to be the sum of the
Value of the Firm

16-5
1.Why should the stockholders care about
maximizing firm value? Perhaps they should be

interested in strategies that maximize
shareholder value.
2.What is the ratio of debt-to-equity that
maximizes the shareholders value?
There are two important questions:
As it turns out, changes in capital structure only

benefit the stockholders if the value of the firm
increases.
16-6
Current
Assets
Rs.20,000
Debt
Rs.0
Equity
Rs.20,000
Debt/Equity ratio 0.00
Interest rate
n/a
Shares outstanding400
Share price
Rs.50
Proposed
Rs.20,000
Rs.8,000
Rs.12,000
2/3
8%
240
Rs.50
Consider an all-equity firm that is contemplating going

into debt. (Maybe some of the original shareholders want
to cash out.)
16-7
Expansion
Rs.3,000
0
Rs.3,000
Rs.7.50
15%
15%
shares
Recession Expected
EBIT
Rs.1,000 Rs.2,000
Interest
0
0
Net income Rs.1,000 Rs.2,000
EPS
Rs.2.50
Rs.5.00
ROA
5%
10%
ROE
5%
10%
Current Shares Outstanding = 400
16-8
Recession Expected Expansion

EBIT
Rs.1,000 Rs.2,000 Rs.3,000
Interest
640
640
640
Net income
Rs.360 Rs.1,360 Rs.2,360
EPS
Rs.1.50
Rs.5.67
Rs.9.83
ROA
1.8%
6.8%
11.8%
ROE
3.0%
11.3%
19.7%
Proposed Shares Outstanding = 240 shares
16-9
Debt
10.00
EPS
8.00
6.00
4.00
No Debt
Advantage
to debt
Break-even
point
12.00
2.00
0.00
1,000
(2.00)
Disadvantage
to debt
2,000
3,000
EBIT in dollars, no taxes

16-10
Perfect Capital Markets:

Perfect competition
Firms and investors can borrow/lend at the
same rate
Equal access to all relevant information
No transaction costs
No taxes
Homogeneous Expectations
Homogeneous Business Risk Classes
Perpetual Cash Flows
16-11

EPS of Unlevered Firm Rs.2.50 Rs.5.00 Rs.7.50
Earnings for 40 shares Rs.100
Rs.200 Rs.300
Less interest on Rs.800 (8%)Rs.64 Rs.64 Rs.64
Net Profits
Rs.36 Rs.136 Rs.236
ROE (Net Profits / Rs.1,200) 3.0% 11.3% 19.7%
We are buying 40 shares of a Rs.50 stock, using Rs.800 in margin.

We get the same ROE as if we bought into a levered firm.
Our personal debt-equity ratio is:
B
Rs.800
Rs.1,200
3
16-12
Buying 24 shares of an otherwise identical levered firm

along with some of the firms debt gets us to the ROE of the
unlevered firm.
This is the fundamental insight of M&M

EPS of Levered FirmRs.1.50
Rs.5.67
Rs.9.83
Earnings for 24 sharesRs.36
Rs.136
Rs.236
Plus interest on Rs.800 (8%)Rs.64 Rs.64
Rs.64
Net Profits
Rs.100Rs.200Rs.300
ROE (Net Profits / Rs.2,000)5% 10%15%
16-13
position by adjusting the trading in our

own account.
This homemade leverage suggests that
capital structure is irrelevant in

determining the value of the firm:
We can create a levered or unlevered
VL = V U
16-14
to stockholders
Rs = R0 + (B / SL) (R0 - RB)
RB is the interest rate (cost of debt)
Rs is the return on (levered) equity (cost of
equity)
R0 is the return on unlevered equity (cost of
capital)
B is the value of debt
SL is the value of levered equity
Proposition II
Leverage increases the risk and return
16-15
B
S
R
R
T
h
e
n
s
t
R
R
W
A
C
B
S
W
A
C
0
S
B
B
B
R
R
m
u
l
t
i
p
y
b
o
t
h
s
i
d
e
b
y
B
S
0
SB
B
B
S
B
R
B
S
0
S
B
S
B
R
B
S
0
SB
B
S(R
)
S
0B
0
SS
00R
The derivation is straightforward:
16-16
R0
RB
RB
Cost of capital: R (%)
B
R
(
R
)
S
0B
0
S
L
B
S
R
R
W
A
C
S
SBB
B
S
Debt-to-equity Ratio
16-17
Firm value increases with leverage
V L = VU + T C B
Proposition II (with Corporate Taxes)
Some of the increase in equity risk and return is
offset by the interest tax shield

RS = R0 + (B/S)(1-TC)(R0 - RB)
RB is the interest rate (cost of debt)
RS is the return on equity (cost of equity)
R0 is the return on unlevered equity (cost of capital)
B is the value of debt
S is the value of levered equity
Proposition I (with Corporate Taxes)
16-18
The present value of this stream of cash flows is VL
eC
T
tlear(yoE
h
aB
lIcT
s
hR
fB
lBoB
w
tB)(1a)
l
s
eE
lT
rCB
i)ICT
k
h
o
d
s
R
B
B
B
(1TC
)V
R
(L
B
1R
R
B
B
C
B
B
B
T
B
U
C
The present value of the first term is VU
The present value of the second term is TCB
16-19
Since
The cash flows from each side of the balance sheet must equal:
T
B
L
U
C
V
S
T
B
L
U
C
V
(
1
)
U
C
S
R
B
V
R
T
B
R
S
B
U
0
C
B
R
[
S
(
1
)
]
T
R
B
0
C
B
B
R
R
[1(R
)S]R
T
SS
B
C
0
C
B
S
B
(1T)(R
)
0
B
Start with M&M Proposition I with taxes:
Divide both sides by S
Which quickly reduces to
16-20
R0
B
R
(
R
)
S
0B
0
S
L
T
(
R
)
S0L1
C
0
B
B
S
L
R
R
(
1
T
)
W
A
C
B
C
S
SLBR
Cost of capital: R
(%)
RB
Debt-to-equity
16-21
All Equity
Levered
Total Cash Flow to S/H
Expected
Rs.2,000
0
Rs.2,000
Rs.700
Expansion
Rs.3,000
0
Rs.3,000
Rs.1,050
Rs.650
Rs.1,300
Rs.1,950
RecessionExpected
Expansion
EBIT
Rs.1,000Rs.2,000 Rs.3,000
Interest (Rs.800 @ 8% )
640640
640
EBT
Rs.360Rs.1,360 Rs.2,360
Taxes (Tc = 35%)
Rs.126Rs.476
Rs.826
Total Cash Flow
Rs.234+640Rs.884+Rs.640Rs.1,534+Rs.640
(to both S/H & B/H):
Rs.874Rs.1,524 Rs.2,174
EBIT(1-Tc)+TCRBB
Rs.650+Rs.224Rs.1,300+Rs.224Rs.1,950+Rs.224
Rs.874Rs.1,524 Rs.2,174
EBIT
Interest
EBT
Taxes (Tc = 35%)
Recession
Rs.1,000
0
Rs.1,000
Rs.350
16-22
Levered firm
S
The levered firm pays less in taxes than does the all-equity firm.
Thus, the sum of the debt plus the equity of the levered firm is
greater than the equity of the unlevered firm.
All-equity firm
This is how cutting the pie differently can make the pie larger.
-the government takes a smaller slice of the pie!
16-23
by capital structure.
This is M&M Proposition I:
VL = VU
Proposition I holds because shareholders can achieve any
pattern of payouts they desire with homemade leverage.

In a world of no taxes, M&M Proposition II states that
leverage increases the risk and return to stockholders.
B
R
SL
(R
)
S
0B
0
In a world of no taxes, the value of the firm is unaffected
16-24
of the firm increases with leverage.

This is M&M Proposition I:
VL = VU + TC B
Proposition I holds because shareholders can achieve
any pattern of payouts they desire with homemade
leverage.
In a world of taxes, M&M Proposition II states that
leverage increases the risk and return to stockholders.
B
R
(SL1T
)(R
)
S
0
C
0
B
In a world of taxes, but no bankruptcy costs, the value
16-25
maximizing firm value rather than just the

value of the equity?
How does financial leverage affect firm
value without taxes? With taxes?
Why should stockholders care about
What is homemade leverage?
16-26

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Chap 016

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Randolph W.

Capital Structure: Basic Concepts

(i.e., capital structure) on firm earnings

and without taxes

Understand the effect of financial leverage

Be able to compute the value of the

unlevered and levered firm

16.2 Maximizing Firm Value versus Maximizing

16.1 The Capital Structure Question and The Pie

value of the firms debt and the firms equity.

The value of a firm is defined to be the sum of the

Value of the Firm

1.Why should the stockholders care about

maximizing firm value? Perhaps they should be

There are two important questions:

As it turns out, changes in capital structure only

Consider an all-equity firm that is contemplating going

Recession Expected Expansion

EBIT in dollars, no taxes

Perfect Capital Markets:

Recession Expected Expansion

We are buying 40 shares of a Rs.50 stock, using Rs.800 in margin.

Buying 24 shares of an otherwise identical levered firm

Recession Expected Expansion

position by adjusting the trading in our

capital structure is irrelevant in

We can create a levered or unlevered

The derivation is straightforward:

Firm value increases with leverage

offset by the interest tax shield

Proposition I (with Corporate Taxes)

The present value of this stream of cash flows is VL

The present value of the first term is VU

The present value of the second term is TCB

Start with M&M Proposition I with taxes:

Divide both sides by S

Which quickly reduces to

Total Cash Flow to S/H

Proposition I holds because shareholders can achieve any

pattern of payouts they desire with homemade leverage.

In a world of no taxes, the value of the firm is unaffected

of the firm increases with leverage.

In a world of taxes, but no bankruptcy costs, the value

maximizing firm value rather than just the

value without taxes? With taxes?

Why should stockholders care about

What is homemade leverage?

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