Chapter 16

Capital Structure: Basic Concepts

McGraw-Hill/Irwin Copyright © 2010 by the McGraw-Hill Companies, Inc. All rights reserved.
Key Concepts and Skills
 Understand the effect of financial leverage
(i.e., capital structure) on firm earnings
 Understand homemade leverage
 Understand capital structure theories with and
without taxes
 Be able to compute the value of the unlevered
and levered firm

16-1
Chapter Outline
16.1 The Capital Structure Question and The Pie Theory
16.2 Maximizing Firm Value versus Maximizing
Stockholder Interests
16.3 Financial Leverage and Firm Value: An Example
16.4 Modigliani and Miller: Proposition II (No Taxes)
16.5 Taxes

16-2
16.1 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
16-3
Stockholder Interests
There are 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?

As it turns out, changes in capital structure

benefit the stockholders if and only if the value
of the firm increases.
16-4
16.3 Financial Leverage, EPS, and ROE
Consider an all-equity firm that is contemplating 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 16-5
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 16-6
EPS and ROE Under Proposed 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 1.8% 6.8% 11.8%
ROE 3.0% 11.3% 19.7%
Proposed Shares Outstanding = 240 shares 16-7
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 16-8
Assumptions of the M&M 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

16-9
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) 3.0% 11.3% 19.7%
We are buying 40 shares of a $50 stock, using $800 in margin.
We get the same ROE as if we bought into a levered firm.

B $800 2
Our personal debt-equity ratio is:  
S $1,200 3 16-10
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 otherwise identical levered firm along
with some of the firm’s debt gets us to the ROE of the unlevered
firm.
This is the fundamental insight of M&M

16-11
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

16-12
16.4 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

16-13
MM Proposition II (No Taxes)
The derivation is straightforward:
B S
RW ACC   RB   RS Then set RWACC  R0
BS BS
B S BS
 RB   RS  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
 RB  RS  R0  R0 RS  R0  ( R0  RB )
S S S
16-14
MM Proposition II (No Taxes)
Cost of capital: R (%)

B
RS  R0   ( R0  RB )
SL

B S
R0 RW ACC   RB   RS
BS BS

RB RB

Debt-to-equity Ratio B
S
16-15
16.5 MM Propositions I & II (With 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 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 16-16
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  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 16-17
MM Proposition II (With Taxes)
Start with M&M Proposition I with taxes: VL  VU  TC B
Since VL  S  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
Which quickly reduces to RS  R0   (1  TC )  ( R0  RB )
S 16-18
The Effect of Financial Leverage
Cost of capital: R B
(%) RS  R0   ( R0  RB )
SL

B
RS  R0   (1  TC )  ( R0  RB )
SL

R0

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

Debt-to-equity
ratio (B/S) 16-19
Total Cash Flow to Investors
Recession Expected Expansion
EBIT $1,000 $2,000 $3,000
Interest 0 0 0
All Equity

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

Recession Expected Expansion

EBIT $1,000 $2,000 $3,000
Interest ($800 @ 8% ) 640 640 640
Levered

EBT $360 $1,360 $2,360

Taxes (Tc = 35%) $126 $476 $826
Total Cash Flow $234+640 $884+$640 $1,534+$640
(to both S/H & B/H): $874 $1,524 $2,174
EBIT(1-Tc)+TCRBB $650+$224 $1,300+$224 $1,950+$224
$874 $1,524 $2,174 16-20
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!

16-21
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
16-22
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
RS  R0   (1  TC )  ( R0  RB )
SL

16-23
Quick Quiz
 Why should stockholders care about
maximizing firm value rather than just the
value of the equity?
 How does financial leverage affect firm value
without taxes? With taxes?
 What is homemade leverage?

16-24