Capital Structure

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
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 S B
of the firm is to make the firm as
valuable as possible, the the firm
should pick the debt-equity ratio
that makes the pie as big as
possible.
Value of the Firm
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.
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 Proposed
Assets $20,000 $20,000
Debt $0 $8,000
Equity $20,000 $12,000
Debt/Equity ratio 0.00 2/3
Interest rate n/a 8%
Shares outstanding 400 240
Share price $50 $50
EPS and ROE Under Current
Capital 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

EPS and ROE Under Proposed
Capital Structure
Recession Expected Expansion
EBIT $1,000 $2,000 $3,000
Interest 640 640 640
Net income $360 $1,360 $2,360
EPS $1.50 $5.67 $9.83
ROA 5% 10% 15%
ROE 3% 11% 20%

Proposed Shares Outstanding = 240 shares

EPS and ROE Under Both Capital
Structures All-Equity
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

Levered
Recession Expected Expansion
EBIT $1,000 $2,000 $3,000
Interest 640 640 640
Net income $360 $1,360 $2,360
EPS $1.50 $5.67 $9.83
ROA 5% 10% 15%
ROE 3% 11% 20%
Proposed Shares Outstanding = 240 shares
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
to debt EBIT
EBI in dollars, no taxes
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
Homemade Leverage: An Example
Recession Expected Expansion
EPS of Unlevered Firm $2.50 $5.00 $7.50
Earnings for 40 shares $100 $200 $300
Less interest on $800 (8%) $64 $64 $64
Net Profits $36 $136 $236
ROE (Net Profits / $1,200) 3% 11% 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

S $1,200 3
Homemade (Un)Leverage: An
Example
Recession Expected Expansion
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

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)
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
The Cost of Equity, the Cost of Debt, and the
Weighted Average Cost of Capital: MM
Proposition II with No Corporate Taxes
Cost of capital: r (%)

B
rS r0 (r0 rB )
SL

B S
r0 rWACC rB rS
BS BS

rB rB

B
Debt-to-equity Ratio
S
Implications of the MM No-Tax
Propositions
Capital structure is irrelevant in an MM world
without corporate taxes.
VL = V U
The value of the firm (size of the pie) is
determined by the firms capital budgeting
decisions. Capital structure determines only
how the pie is sliced.
Increasing the extent to which a firm relies on
debt increases both the risk and the expected
return to equity but not the price per share.
The MM Propositions I & II (with Corporate
Taxes)

Proposition I (with Corporate Taxes)

Firm value increases with leverage
VL = V U + T C B
Proposition II (with Corporate Taxes)
Some of the increase in equity risk and return is offset by
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
The Effect of Financial Leverage on
the Cost of Debt and Equity Capital
Cost of capital: r
(%)

B
rS r0 (1 TC ) (r0 rB )
SL

r0
B SL
rWACC rB (1 TC ) rS
BSL B SL
rB

Debt-to-equity
ratio (B/S)
Total Cash Flow to Investors Under
Each Capital Structure with Corp. Taxes
All-Equity
Recession Expected Expansion
EBIT $1,000 $2,000 $3,000
Interest 0 0 0
EBT $1,000 $2,000 $3,000
Taxes (Tc = 35% $350 $700 $1,050
Total Cash Flow to S/H $650 $1,300 $1,950

Levered
Recession Expected Expansion
EBIT $1,000 $2,000 $3,000
Interest ($800 @ 8% ) 640 640 640
EBT $360 $1,360 $2,360
Taxes (Tc = 35%) $126 $476 $826
Total Cash Flow $234+640 $468+$640 $1,534+$640
(to both S/H & B/H): $874 $1,524 $2,174
EBIT(1-Tc)+TCrBB $650+$242 $1,300+$224 $1,950+$224
$874 $1,524 $2,174
Total Cash Flow to Investors Under
Each Capital Structure with Corp. Taxes

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.
An Example (no taxes):
Imagine you have discovered an investment
alternative which produces expected EBIT of $1,000
forever. Similar (unlevered) projects in the market
have a required return r0 of 10%. You must put up
$5,000 of your own money to invest in this project.

You have two financing alternatives:

Unlevered: you issue yourself $5,000 in equity, SU
Levered: you sell yourself $1,000 debt, B, and $4,000
equity S. The debt pays the market rate rB of 5%.
Example, continued
Annual cash flows, depending on your choice
of financing, are:
Unlevered Levered
EBIT $1,000 $1,000
Interest -50 (rB*B)
EBT 1,000 950
Tax (0%)
Net Income 1,000 950
CF(B+S) $1,000 $1,000
Example continued,
Proposition I:
VU=SU=EBIT/r0 = $1,000/.1=$10,000
VL= B + S = $10,000
S = $10,000 - $1,000 = $9,000
Example, continued
Proposition II:
rS = r0 + (B/S)(r0 - rB )
r0 = .10 + ($0/$10,000)(.10-.05) = 10%
rS = .10 +($1,000/$9,000)(.10-.05)=10.56%
WACC = (1,000/10,000)(5%) +
(9,000/10,000)(10.56%) = 10% = r0
An Example of MM Propositions
I & II with Corporate Taxes
Consider the same investment and financing
alternatives as for the no tax example, but now TC =
34%,
Unlevered Levered
EBIT $1,000 $1,000
Interest -50
EBT 1,000 950
Tax(34%) -340 -323
Net Income 660 627
CF(B+S) $660 $677
A Debt versus Equity
Problem
The market value of a firm that has $500,000

in debt is $1,700,000. The expected value of

EBIT is a perpetuity. The interest rate on
debt (pretax) is 10%. The company is
subject to a 34% tax rate. If the company
were 100% equity financed, the equity
holders would have a 20% required return.
What is the net income of the firm? What
would be the market value of the firm if it
were 100% equity financed?
Example Continued
VL=VU + TCB
$1,700 = VU + (.34)*($500)
=> VU =$1,530
VU = EBIT (1- TC )/r0
$1,530 = EBIT *(1-.34)/.2
=> EBIT = $463, 636
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

B
rS r0 (r0 rB )
SL
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.

B
rS r0 (1 TC ) (r0 rB )
SL
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.