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Capital Structure: Basic Concepts Chapter 16 Copyright © 2010 by the McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin
Capital Structure: Basic Concepts
Chapter 16
Copyright © 2010 by the McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin
16-2
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
16-3
Chapter Outline16.1 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
16-4
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 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
S BS BS BS B
16-5
Stockholder InterestsThere 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.
16-6
16.3 Financial Leverage, EPS, and ROE
CurrentAssets $20,000Debt $0Equity $20,000Debt/Equity ratio 0.00Interest rate n/aShares outstanding 400Share price $50
Proposed$20,000
$8,000$12,000
2/38%240$50
Consider an all-equity firm that is contemplating going into debt. (Maybe some of the original shareholders want to cash out.)
16-7
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
16-8
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
16-9
Financial Leverage and EPS
(2.00)
0.00
2.00
4.00
6.00
8.00
10.00
12.00
1,000 2,000 3,000
EP
S
Debt
No Debt
Break-even point
EBIT in dollars, no taxes
Advantage to debt
Disadvantage to debt
16-10
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
16-11
Homemade Leverage: An ExampleRecession 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 $800 in margin. We get the same ROE as if we bought into a levered firm.
Our personal debt-equity ratio is: 32
200,1$
800$
S
B
16-12
Homemade (Un)Leverage: An ExampleRecession Expected Expansion
EPS of Levered Firm $1.50 $5.67 $9.83Earnings for 24 shares $36 $136 $236Plus interest on $800 (8%) $64 $64 $64Net Profits $100 $200 $300ROE (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
16-13
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
16-14
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
16-15
MM Proposition II (No Taxes)The derivation is straightforward:
SBWACC RSB
SR
SB
BR
0set Then RRWACC
0RRSB
SR
SB
BSB
S
SB by sidesboth multiply
0RS
SBR
SB
S
S
SBR
SB
B
S
SBSB
0RS
SBRR
S
BSB
00 RRS
BRR
S
BSB )( 00 BS RR
S
BRR
16-16
MM Proposition II (No Taxes)
Debt-to-equity Ratio
Cos
t of
capi
tal:
R (
%)
R0
RB
SBWACC RSB
SR
SB
BR
)( 00 BL
S RRS
BRR
RB
S
B
16-17
16.5 MM Propositions I & II (With Taxes) Proposition I (with Corporate Taxes)
Firm value increases with leverageVL = VU + TC B
Proposition II (with Corporate Taxes) Some of the increase in equity risk and return is offset by the
interest tax shieldRS = 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 debtS is the value of levered equity
16-18
MM Proposition I (With Taxes)
BTVV CUL
BRTBREBIT BCB )1()(
is rsstakeholde all toflowcash totalThe
The present value of this stream of cash flows is VL
BRTBREBIT BCB )1()(Clearly
The present value of the first term is VU
The present value of the second term is TCB
BRTBRTEBIT BCBC )1()1(
BRBTRBRTEBIT BCBBC )1(
16-19
MM Proposition II (With Taxes)Start with M&M Proposition I with taxes:
)()1( 00 BCS RRTS
BRR
BTVV CUL
Since BSVL
The cash flows from each side of the balance sheet must equal:
BCUBS BRTRVBRSR 0
BRTRTBSBRSR BCCBS 0)]1([
Divide both sides by S
BCCBS RTS
BRT
S
BR
S
BR 0)]1(1[
BTVBS CU
)1( CU TBSV
Which quickly reduces to
16-20
The Effect of Financial Leverage
Debt-to-equityratio (B/S)
Cost of capital: R(%)
R0
RB
)()1( 00 BCL
S RRTS
BRR
SL
LCB
LWACC R
SB
STR
SB
BR
)1(
)( 00 BL
S RRS
BRR
16-21
Total Cash Flow to InvestorsRecession Expected Expansion
EBIT $1,000 $2,000 $3,000Interest 0 0 0EBT $1,000 $2,000 $3,000Taxes (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
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
All
Equ
ity
Lev
ered
16-22
Total Cash Flow to Investors
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!
S G S G
B
All-equity firm Levered firm
16-23
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
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.
)( 00 BL
S RRS
BRR
16-24
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 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.
)()1( 00 BCL
S RRTS
BRR
16-25
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?
