Capital

Structure
Building blocks

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 Concepts
• Capital structure (financial leverage) and
firm earnings

• Homemade leverage

• Capital structure theories with and without

taxes

• Value of the unlevered and levered firm

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 Capital Structure and the Pie
• The value of a firm is defined to be the sum of the
value of the firm’s debt and the firm’s equity.
V=B+S

• If the goal of the firm’s

management is to make the S B
firm as valuable as possible,
then the firm should pick the
debt-equity ratio that makes
the pie as big as possible.
Value of the Firm
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 Stockholder Interests
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 shareholder’s value?

Changes in capital structure benefit the

stockholders if and only if the value of the firm
increases.
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 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.)
Proposed
Current
$20,000
Assets $20,000
$8,000
Debt $0
$12,000
Equity $20,000
2/3
Debt/Equity ratio 0.00
8%
Interest rate n/a
240 outstanding
Shares 400
$50 price
Share $50
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 EPS and ROE Under Current
Structure
Recession Expected Expansion
EBIT $1,000 $2,000 $3,000
Interest 0 0 0
Net income $1,000 $2,000 $3,000
EPS $2.50 $5.00 $7.50
ROA 5% 10% 15%
ROE 5% 10% 15%
Current Shares Outstanding = 400 shares 6
 EPS and ROE Under Proposed
Structure
RecessionExpectedExpansion
EBIT $1,000$2,000$3,000
Interest 640640 640
Net income $360$1,360$2,360
EPS $1.50$5.67$9.83
ROA 1.8%6.8%11.8%
ROE 3.0%11.3%19.7%
Proposed Shares Outstanding = 240 shares

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 EBIT and Leverage
AAA co. has no debt outstanding and a total market
value of $150,000. Earnings before interest and tax,
EBIT, are projected to be $14,000 if economic
conditions are normal. If there is strong expansion in
the economy, then EBIT will be 30 percent higher. If
there is a recession, then EBIT will be 60 per cent
lower. AAA is considering a $60,000 debt issue with a
5 per cent interest rate. The proceeds will be used to
repurchase shares of stock. There are currently 2,500
shares outstanding. Ignore taxes for this problem.

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Calculate earnings per share (EPS) under each of
the three economic scenarios before any debt is
issued. Also, calculate the percentage changes in
EPS when the economy expands or enters a
recession.

Repeat the above procedure assuming that AAA

goes through with recapitalisation. What do you
observe?

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 Financial Leverage and EPS
12.00

10.00 Debt

8.00 No Debt

6.00 Break-even Advantage

EPS

point to debt
4.00

2.00

0.00
1,000 2,000 3,000
(2.00) Disadvantage EBIT in dollars, no taxes
to debt
 Break even EBIT
BBB Co. is comparing two different capital
structures, an all-equity plan (Plan I) and a
levered plan (Plan II). Under Plan I, BBB would
have 150,000 shares of stock outstanding. Under
Plan II, there would be 60,000 shares of stock
outstanding and $1.5 million in debt
outstanding. The interest rate on debt is 10 per
cent and there are no taxes.

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1. If EBIT is $220,000, which plan will result in the
higher EPS?

2. If EBIT is $650,000, which plan will result in the

higher EPS?

3. What is the break-even EBIT?

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 Assumptions of the
Modilgliani & Miller (MM) 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

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 Financial Leverage, ROE and EPS
Current Proposed
Assets $8 mil $8 mil
Debt 0 $4 mil (at 10% interest)
Equity $8 mil $4 mil
Debt equity ratio 0 1
Share price $20 $20
Shares outstanding 400k 200k

Current capital structure (No debt) Proposed capital (D=$4mil)

Equity=$8mil, o/shares=400k Equity=$4mil, o/shares=200k
Bad Normal Good Bad Normal Good

EBIT 500k 1mil 1.5mil 500k 1mil 1.5mil

Interest 0 0 0 400k 400k 400k
EBT (NI) 500k 1mil 1.5mil 100k 600k 1.1mil
ROE = NI/Equity 6.25% 12.5% 18.75% 2.5% 15% 27.5%
EPS=NI/o.share $1.25 $2.5 $3.75 $0.5 $3 $5.5

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 Example: Financial Leverage, EPS
and ROE
• Variability in Return on Equity (ROE)
Current: ROE ranges from 6.25% to 18.75%
Proposed: ROE ranges from 2.50% to 27.50%

• Variability in Earnings per share (EPS)

Current: EPS ranges from $1.25 to $3.75
Proposed: EPS ranges from $0.50 to $5.50

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 Example: Financial Leverage, EPS
and ROE

The variability in both ROE and EPS increases when

financial leverage is increased.

In other words,
Leverage amplifies the variation in both EPS and ROE

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 Homemade Leverage
Homemade leverage: use of personal borrowing to change
the overall amount of financial leverage to which the
individual is exposed ==>capital structure is irrelevant

Company: Current capital structure (all equity)

Investor prefers the payoff under proposed capital structure

(some equity and some debt)

What does she do?

===> She gets into a levered position (buys more shares by
borrowed funds and pays interest)

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 Homemade Leverage
Homemade leverage: use of personal borrowing to change
the overall amount of financial leverage to which the
individual is exposed ==>capital structure is irrelevant

Consider this situation!

Company: Proposed capital structure (equity + debt)

Investor prefers the payoff under current capital structure

What does she do now?

===> She gets into an unlevered position (sells shares and
lends out the proceeds to earn interest)

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 Homemade Leverage-Example
Example: company is under current capital structure.
An investor is owning 100 shares but prefers the
payoffs under proposed capital structure
• Current Capital Structure==> Proposed Capital Structure
(levered)
 Investor can buy another100 shares of stock by borrowing $2000
(100* $20) @10% interest rate=> total shares = 200
 Payoffs:
• Bad: 200(1.25) - 0.1(2000) = $50
• Normal: 200(2.50) - 0.1(2000) = $300
• Good: 200(3.75) - 0.1(2000) = $550
 Mirrors the payoffs of having 100 shares under the proposed
capital structure

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 Example: Homemade Leverage
Example: company is under the proposed capital
structure. An investor is owning 100 shares but prefers
the payoffs under current capital structure

• Proposed Capital Structure==> Current Capital Structure

(unlevered)
 Investor can sell 50 shares and then lends out the proceeds
(50* $20) $1000 @ 10%. ==> shares left = 50
 Payoffs:
• Bad: 50(.50) + 0.1(1000) = $125
• Normal: 50(3.00) + 0.1(1000) = $250
• Good: 50(5.50) + 0.1(1000) = $375
 Mirrors the payoffs of having 100 shares under the current
capital structure
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 Homemade Leverage –
assignment question
CCC Co., a prominent consumer products firm, is
debating whether or not to convert its all-equity
capital structure to one that is 40 per cent debt.
Currently, there are 2000 shares outstanding and
the price per share is Rs. 70. EBIT is expected to
remain at Rs. 16,000 per year forever. The interest
rate on new debt is 8 per cent, and there are no
taxes.

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1. Mr. Lal, a shareholder of the firm, owns 100
shares of stock. What is his cash flow under the
current capital structure, assuming the firm has
a dividend payout rate of 100 per cent?

2. What will Mr. Lal’s cash flow be under the

proposed capital structure of the firm? Assume
that he keeps all 100 of his shares.

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3. Suppose CCC does convert, but Mr. Lal
prefers the current all-equity capital
structure. Show how he could unlever his
shares of stock to create the original capital
structure.

4. Using your answer to part 3, explain why

CCC’s choice of capital structure is
irrelevant.

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 MM Proposition I (No Taxes)
• We can create a levered or unlevered
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:
VL = VU
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 MM Prop I without Taxes
For BBB Co. use MM Proposition I to find the price
per share of equity under each of the two proposed
plans.

What is the value of the firm?

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 MM Proposition II (No Taxes)
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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MM Proposition II (No Taxes)
The derivation is straightforward:
B S
RW ACC   RB   RS Then set RW ACC  R 0
BS BS
B S BS
 RB   R S  R0 multiply both sides by
BS BS 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 B
 R B  R S  R0  R0 R S  R0  ( R0  R B )
S S S
 MM Proposition II (No Taxes)
Cost of capital: R (%)

B
R S  R0   ( R0  R B )
SL

B S
R0 RW ACC   RB   RS
BS BS

RB RB

Debt-to-equity Ratio B 28
S
 MM Propositions I & II (With Taxes)

MM Proposition I (with corporate taxes)

 Firm value increases with leverage

VL = VU + TC B

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MM Proposition I (With Taxes)
The total cash flow to all stakeholde rs is
( EBIT  RB B )  (1  TC )  RB B
The present value of this stream of cash flows is VL
Clearly ( EBIT  R B B )  (1  TC )  R B B 
 EBIT  (1  TC )  R B B  (1  TC )  R B B
 EBIT  (1  TC )  R B B  R B BT C  R B B
The present value of the first term is VU
The present value of the second term is TCB
 V L  VU  TC B
 MM Propositions I & II (With Taxes)

MM 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

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MM Proposition II (With Taxes)
Start with M&M Proposition I with taxes: V L  VU  TC B
Since V L  S  B  S  B  VU  TC B
VU  S  B (1  TC )
The cash flows from each side of the balance sheet must equal:
SR S  BR B  VU R 0  TC BR B
SR S  BR B  [ S  B (1  TC )] R 0  TC R B B
Divide both sides by S
B B B
RS  R B  [1  (1  TC )] R0  TC R B
S S S
B
Which quickly reduces to R S  R0   (1  TC )  ( R0  R B )
S
 MM and Taxes
DDD Co. expects its EBIT to be $95,000 every
year forever. The firm can borrow at 10 per
cent. DDD currently has no debt, and its cost of
equity is 22 per cent. If the tax rate is 35 per
cent, what is the value of the firm?

What will the value be if DDD borrows $60,000

and uses the proceeds to repurchase the shares?

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 Value of the Firm
EEE Co. expects an EBIT of $9000 every
year forever. EEE currently has no debt,
and its cost of equity is 18 per cent. The firm
can borrow at 10 per cent. If the corporate
tax rate is 35 per cent, what is the value of
the firm?

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 Value of the Firm
 If the firm converts to 50% debt, what will be
the value of the levered firm?

 If the firm converts to 100% debt, what will be

the value of the levered firm?

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 The Effect of Financial Leverage
Cost of capital: R B
(%)
R S  R0   ( R0  R B )
SL

B
R S  R0   (1  TC )  ( R0  R B )
SL

R0

B SL
RW ACC   R B  (1  TC )   RS
BSL B  SL
RB

Debt-to-equity
ratio (B/S)
 Cost of Equity and WACC
– assignment question
FFF Co. has no debt but can borrow at 8 per cent.
The firm’s WACC is currently 12 per cent, and the
tax rate is 35 per cent.

1. What is FFF’s cost of equity?

2. If the firm converts to 10 per cent debt, what will its

cost of equity be?
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 Cost of Equity and WACC –
assignment question (cont...)

3. If the firm converts to 50 per cent debt, what will

its equity be?

4. What is FFF’s WACC is parts 2 and 3 above?

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 Total Cash Flow to Investors
All-equity firm Levered firm

S G S G

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.
This is how cutting the pie differently can make the pie “larger.”
-the government takes a smaller slice of the pie! 39
 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
 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
RS  R0   ( R0  RB )
SL
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 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
 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 S  R0   (1  TC )  ( R0  R B )
SL
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 The tale thus far . . .
 In a world of no taxes, firms should not worry about their
capital structure

 In a world where taxes exist, all firms should take on as

much debt as possible (perhaps close to 100 per cent)

 In reality (in a world of taxes), we do not see firms taking

on too much of debt. Is there a necessity to modify the
framework discussed thus far to explain this?

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