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Chapter Fifteen
Capital Structure:
Basic
Corporate
Finance
Ross Westerfield Jaffe
Concepts
15
Sixth Edition
Prepared by
Gady Jacoby
University of Manitoba
and
Sebouh Aintablian
American University of
Beirut
McGraw-Hill Ryerson
15-2
Chapter Outline
15.1 The Capital-Structure Question and The Pie Theory
15.2 Maximizing Firm Value versus Maximizing
Stockholder Interests
15.3 Financial Leverage and Firm Value: An Example
15.4 Modigliani and Miller: Proposition II (No Taxes)
15.5 Taxes
15.6 Summary and Conclusions
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15-4
15-5
Current
$20,000
$0
$20,000
0.00
n/a
400
$50
Proposed
$20,000
$8,000
$12,000
2/3
8%
240
$50
2003 McGrawHill Ryerson Limited
15-6
EBIT
Interest
Net income
EPS
ROA
ROE
Recession
$1,000
0
$1,000
$2.50
5%
5%
Expected Expansion
$2,000
$3,000
0
0
$2,000
$3,000
$5.00
$7.50
10%
15%
10%
15%
15-7
EBIT
Interest
Net income
EPS
ROA
ROE
Recession
$1,000
640
$360
$1.50
5%
3%
Expected Expansion
$2,000
$3,000
640
640
$1,360
$2,360
$5.67
$9.83
10%
15%
11%
20%
15-8
EBIT
Interest
Net income
EPS
ROA
ROE
Levered
Recession
$1,000
640
$360
$1.50
5%
3%
Expected
$2,000
0
$2,000
$5.00
10%
10%
Expansion
$3,000
0
$3,000
$7.50
15%
15%
Expected
$2,000
640
$1,360
$5.67
10%
11%
Expansion
$3,000
640
$2,360
$9.83
15%
20%
15-9
10.00
EPS
8.00
6.00
4.00
No Debt
Advantage
to debt
Break-even
point
2.00
0.00
1,000
(2.00)
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Disadvantage
to debt
2,000
3,000
EBIT
EBI in dollars, no taxes
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15-10
Homogeneous Expectations
Homogeneous Business Risk Classes
Perpetual Cash Flows
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
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15-11
$100
$64
$36
3%
$200
$64
$136
11%
$300
$64
$236
20%
3
S $1,200
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15-12
$136
$64
$200
10%
$236
$64
$300
15%
15-13
Proposition II
Leverage increases the risk and return 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
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EBIT rB B
Bondholders receive
rB B
( EBIT rB B ) rB B EBIT
The present value of this stream of cash flows is VU
VL VU
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15-15
B
S
rB
rS
BS
BS
B
S
rB
rS r0
BS
BS
BS
S
BS
B
BS
S
BS
rB
rS
r0
S
BS
S
BS
S
B
BS
rB rS
r0
S
S
B
B
rB rS r0 r0
S
S
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B
rS r0 (r0 rB )
S
2003 McGrawHill Ryerson Limited
15-16
r0
rS r0
rWACC
B
(r0 rB )
SL
B
S
rB
rS
BS
BS
rB
rB
Debt-to-equity Ratio
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B
S
15-17
15.5 Taxes
The MM Propositions I & II (with Corporate Taxes)
Proposition I (with Corporate Taxes)
Firm value increases with leverage
VL = VU + TC B
15-18
EBIT (1 TC ) rB B (1 TC ) rB B
EBIT (1 TC ) rB B rB BTC rB B
The present value of the first term is VU
The present value of the second term is TCB
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VL VU TC B
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VL S B S B VU TC B
VU S B (1 TC )
The cash flows from each side of the balance sheet must equal:
B
rS r0 (1 TC ) (r0 rB )
S
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15-20
rS r0
B
(1 TC ) (r0 rB )
SL
r0
rWACC
B
SL
rB (1 TC )
rS
BSL
B SL
rB
Debt-to-equity
ratio (B/S)
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15-21
Recession
$1,000
0
$1,000
$350
Expected
$2,000
0
$2,000
$700
Expansion
$3,000
0
$3,000
$1,050
$650
$1,300
$1,950
LeveredRecession
EBIT
Interest ($800 @ 8% )
EBT
Taxes (Tc = 35%)
Total Cash Flow
(to both S/H & B/H):
EBIT(1-Tc)+TCrBB
$1,000$2,000
$3,000
640640
640
$360$1,360
$2,360
$126$476
$826
$234+640$468+$640$1,534+$640
$874$1,524
$2,174
$650+$224$1,300+$224$1,950+$224
$874$1,524
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ExpectedExpansion
$2,174
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15-22
Levered firm
S
The levered firm pays less in taxes than does the allequity firm.
Thus, the sum of the debt plus the equity of the levered
firm is greater than the equity of the unlevered firm.
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Summary: No Taxes
In a world of no taxes, the value of the firm is unaffected by
capital structure.
This is M&M Proposition I:
VL = VU
B
rS r0 (r0 rB )
SL
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15-24
Summary: Taxes
In a world of taxes, but no bankruptcy costs, the value of the
firm increases with leverage.
This is M&M Proposition I:
VL = VU + T C B
B
rS r0 (1 TC ) (r0 rB )
SL
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