Introduc corporate finance ch15

Capital Structure15.1 The Capital-Structure Question and The Pie Theory15.2 Maximizing Firm Value versus Maximizing Stockholder Interests15.3 Financial Leverage and Firm Value: An Exampl

Capital Structure

15.1 The Capital-Structure Question and The Pie

Theory15.2 Maximizing Firm Value versus Maximizing

Stockholder Interests15.3 Financial Leverage and Firm Value: An

Example15.4 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 firm’s debt and the firm’s equity.

 V = B + S

Value of the Firm

S B

• If the goal of the management

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

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 shareholder’s 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

CurrentAssets $20,000

Equity $20,000Debt/Equity ratio 0.00Interest rate n/aShares outstanding 400Share price $50

240

$50Consider an all-equity firm that is considering going into debt (Maybe some of the original shareholders want to cash out.)

EPS and ROE Under Current Capital Structure

Recession Expected Expansion

EPS and ROE Under Proposed Capital Structure

Recession Expected Expansion

EPS and ROE Under Both Capital

Financial Leverage and EPS

(2.00) 0.00 2.00 4.00 6.00 8.00 10.00 12.00

EBI in dollars, no taxes

Advantage

to debt

Disadvantage

Assumptions of the Miller Model

Modigliani- 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

Less interest on $800 (8%) $64 $64 $64

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:

3

2 200

, 1

Homemade (Un)Leverage: An

Example

Recession Expected Expansion

Plus interest on $800 (8%) $64 $64 $64

Buying 24 shares of an other-wise identical levered firm along with the some of the firm’s debt gets us to the ROE of the unlevered firm.

This is the fundamental insight of M&M

The MM Propositions I & II (No

r B is the interest rate (cost of debt)

r s 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

S L 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

S B

S r

S B

r    

r B

S B

Implications of the MM No-Tax Propositions

 Capital structure is irrelevant in an MM world

without corporate taxes.

 VL = VU

 The value of the firm (“size of the pie”) is

determined by the firm’s 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)

 Firm value increases with leverage

V L = V U + T C B

 Some of the increase in equity risk and return is offset by

interest tax shield

r S = r 0 + (B/S)×(1-T C )×(r 0 - r B )

r B is the interest rate (cost of debt)

r S 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

) 1

r      

S L

L C

B L

S B

S T

r S B

Total Cash Flow to Investors Under

Each Capital Structure with Corp Taxes

EBIT(1-Tc)+T C r B B $650+$242 $1,300+$224 $1,950+$224

Total Cash Flow to Investors Under

Each Capital Structure with Corp Taxes

The levered firm pays less in taxes than does the equity firm.

all-Thus, the sum of the debt plus the equity of the levered firm is greater than the equity of the unlevered firm.

B

All-equity firm Levered 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

equity S The debt pays the market rate r B of 5%.

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%,

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?

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:

r    

 In a world of taxes, M&M Proposition II states that leverage

increases the risk and return to stockholders.

)(

)1

r      

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”