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15-1

Capital Structure:
Basic Concepts

15-2

Chapter Outline
The Capital-Structure Question and The Pie
Theory
Maximizing Firm Value versus Maximizing
Stockholder Interests
Financial Leverage and Firm Value: An Example
Modigliani and Miller: Proposition II (No Taxes)
Taxes
Summary and Conclusions

15-3

The Capital-Structure Question


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

S B

Value of the Firm

15-4

The Capital-Structure Question


There are really two important questions:
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?
As it turns out, changes in capital structure benefit the
stockholders if and only if the value of the firm
increases.

15-5

Financial Leverage, EPS, and ROE


Consider an all-equity firm that is considering going
into debt. (Maybe some of the original shareholders
want to cash out.)

Current
Assets
$20,000
Debt
$0
Equity
$20,000
Debt/Equity ratio
0.00
Interest rate
n/a
Shares outstanding
400
Share price
$50

Proposed
$20,000
$8,000
$12,000
2/3
8%
240
$50

15-6

EPS and ROE Under Current Capital


Structure
EBIT
Interest
Net income
EPS
ROA
ROE

RecessionExpectedExpansion
$1,000$2,000$3,000
00
0
$1,000$2,000$3,000
$2.50$5.00 $7.50
5%10% 15%
5%10% 15%

Current Shares Outstanding = 400 shares

15-7

EPS and ROE Under Proposed Capital


Structure
EBIT
Interest
Net income
EPS
ROA
ROE

RecessionExpectedExpansion
$1,000$2,000$3,000
640640
640
$360$1,360$2,360
$1.50$5.67 $9.83
5%10% 15%
3%11%
20%

Proposed Shares Outstanding = 240 shares

15-8

EPS and ROE Under Both Capital Structures


All-Equity

Recession
EBIT
$1,000
Interest
0
Net income
$1,000
EPS
$2.50
ROA
5%
ROE
5%
Current Shares Outstanding = 400 shares

Levered

Recession
EBIT
$1,000
Interest
640
Net income
$360
EPS
$1.50
ROA
5%
ROE
3%
Proposed Shares Outstanding = 240 shares

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

Financial Leverage and EPS


12.00
Debt

10.00

EPS

8.00
6.00
4.00

No Debt

Advantage
to debt

Break-even
point

Disadvantage
to debt

2.00
0.00
1,000
(2.00)

2,000

3,000

EBIT in dollars, no taxes

15-10

Assumptions of the Modigliani-Miller


Model
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

15-11

Homemade Leverage: An Example


EPS of Unlevered Firm

Recession Expected Expansion


$2.50
$5.00
$7.50

Earnings for 40 shares


Less interest on $800 (8%)
Net Profits
ROE (Net Profits / $1,200)

$100
$64
$36
3%

$200
$64
$136
11%

$300
$64
$236
20%

We are buying 40 shares of a $50 stock on margin. We get the same


ROE as if we bought into a levered firm.
Our personal debt equity ratio is:
B
$800 2

3
S $1, 200

15-12

Homemade (Un)Leverage:
An Example
RecessionExpectedExpansion
EPS of Levered Firm
$1.50$5.67$9.83
Earnings for 24 shares
$36$136$236
Plus interest on $800 (8%) $64$64 $64
Net Profits
$100$200$300
ROE (Net Profits / $2,000) 5%10% 15%
Buying 24 shares of an other-wise identical levered firm along with
the some of the firms debt gets us to the ROE of the unlevered firm.
This is the fundamental insight of M&M

15-13

The MM Propositions I & II (No Taxes)


Proposition I
Firm value is not affected by leverage
VL = VU

Proposition II
Leverage increases the risk and return to stockholders
rs = r0 + (B / SL) (r0 - rB)
rB is the interest rate (cost of debt)
r s is the return on (levered) equity (cost of equity)
r 0 is the return on unlevered equity (cost of capital)
B is the value of debt
SL is the value of levered equity

15-14

The MM Proposition II (No Taxes)


The derivation is straightforward:
rWACC

B
S
rB
rS
B S
B S

B
S
rB
rS r0
B S
B S

Then set rWACC r0


B S
multiply both sides by
S

B S
B
B S
S
B S

rB

rS
r0
S
B S
S
B S
S
B
B S
rB rS
r0
S
S

B
B
rB rS r0 r0
S
S

rS r0

B
(r0 rB )
S

15-15

Cost of capital: r (%)

The Cost of Equity, the Cost of Debt, and the Weighted Average Cost
of Capital: MM Proposition II with No Corporate Taxes

r0

rS r0

rWACC

B
(r0 rB )
SL

B
S
rB
rS
BS
BS
rB

rB

B
Debt-to-equity Ratio S

15-16

The MM Propositions I & II


(with Corporate Taxes)
Proposition I (with Corporate Taxes)
Firm value increases with leverage
VL = VU + TC B

Proposition II (with Corporate Taxes)


Some of the increase in equity risk and return is offset by
interest tax shield
r S = r 0 + (B/S)(1-T C)(r 0 - r B)
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

15-17

The MM Proposition I (Corp. Taxes)


Shareholders in a levered firm receive Bondholders receive
( EBIT rB B ) (1 TC )
rB B
Thus, the total cash flow to all stakeholders is
( EBIT rB B ) (1 TC ) rB B
The present value of this stream of cash flows is VL
Clearly ( EBIT rB B ) (1 TC ) rB B
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

VL VU TC B

15-18

The MM Proposition II (Corp. Taxes)


Start with M&M Proposition I with taxes:
Since

VL S B

VL VU TC B

S B VU TC B

VU S B(1 TC )
The cash flows from each side of the balance sheet must equal:

SrS BrB VU r0 TC BrB


SrS BrB [ S B(1 TC )]r0 TC rB B
Divide both sides by S
B
B
B

rS
rB [1
(1 TC )]r0
TC rB
S
S
S
B
rS r0 (1 TC ) (r0 rB )
Which quickly reduces to
S

15-19

The Effect of Financial Leverage on the Cost of Debt and


Equity Capital with Corporate Taxes
rS r0

Cost of capital: r
(%)

rS r0

B
(r0 rB )
SL

B
(1 TC ) (r0 rB )
SL

r0

rWACC

B
SL
rB (1 TC )
rS
BSL
B SL
rB

Debt-to-equity
ratio (B/S)

15-20

Total Cash Flow to Investors Under


Each Capital Structure with Corp. Taxes
All-Equity
EBIT
Interest
EBT
Taxes (Tc = 35%
Total Cash Flow to S/H

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 ($8000 @ 8% )
EBT
Taxes (Tc = 35%)
Total Cash Flow
(to both S/H & B/H):
EBIT(1-Tc)+TCCrBBB

ExpectedExpansion
$1,000$2,000
$3,000
640640
640
$360$1,360
$2,360
$126$476
$826
$234+640$884+$640$1,534+$640
$874$1,524
$2,174
$650+$224$1,300+$224$1,950+$224
$874$1,524
$2,174

15-21

Total Cash Flow to Investors Under


Each Capital Structure with Corp. Taxes
All-equity firm
S

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.

15-22

Total Cash Flow to Investors Under


Each Capital Structure with Corp. Taxes
All-equity firm
S

Levered firm
S

The sum of the debt plus the equity of the levered firm is
greater than the equity of the unlevered firm.
This is how cutting the pie differently can make the pie
larger: the government takes a smaller slice of the pie!

15-23

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

Prop 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
rS r0

B
(r0 rB )
SL

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 + TC B

Prop 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.
rS r0

B
(1 TC ) (r0 rB )
SL

15-25

Prospectus: Bankruptcy Costs


So far, we have seen M&M suggest that financial
leverage does not matter, or imply that taxes cause the
optimal financial structure to be 100% debt.
In the real world, most executives do not like a capital
structure of 100% debt because that is a state known as
bankruptcy.
In the next chapter we will introduce the notion of a
limit on the use of debt: financial distress.
The important use of this chapter is to get comfortable
with M&M algebra.