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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
S B
15-4
15-5
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
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
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
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
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
15-11
$100
$64
$36
3%
$200
$64
$136
11%
$300
$64
$236
20%
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 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
B
S
rB
rS
B S
B S
B
S
rB
rS r0
B S
B 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
15-17
VL VU TC B
15-18
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:
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
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
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
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
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
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
B
(1 TC ) (r0 rB )
SL
15-25