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Original Title: Basics of Capital Structure

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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

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

15-4

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

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

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%

15-7

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%

15-8

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

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

15-10

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

EPS of Unlevered Firm

$2.50

$5.00

$7.50

Less interest on $800 (8%)

Net Profits

ROE (Net Profits / $1,200)

$100

$64

$36

3%

$200

$64

$136

11%

$300

$64

$236

20%

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

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 derivation is straightforward:

rWACC

B

S

rB

rS

B S

B S

B

S

rB

rS r0

B S

B S

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

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

(with Corporate Taxes)

Proposition I (with Corporate Taxes)

Firm value increases with leverage

VL = VU + TC B

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

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

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 [ 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

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

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

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

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

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

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

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.

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