Capital Structure: Basic

Concepts
Chapter 16

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McGraw-Hill/Irwin Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved.
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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
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Outline
• The Capital Structure Question and The Pie Theory

• Maximizing Firm Value versus Maximizing Stockholders’

Value

• Financial Leverage and Firm Value: An Example

• Case 1 (No Taxes): Modigliani and Miller (M&M)

Propositions I and II

• Case 2 (With Taxes): Modigliani and Miller (M&M)

Propositions I and II
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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

S B
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
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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 shareholders’ value.
2. What is the ratio of debt-to-equity that maximizes
the shareholders’ value?

As it turns out, changes in capital structure only benefit

the stockholders if the value of the firm increases.
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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.)

CurrentProposed
Assets$20,000 $20,000
Debt $0 $8,000
Equity $20,000$?
?
Debt/Equity ratio 0.00
8%
Interest rate n/a
?
Shares outstanding 400
$50
Share price $50
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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
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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 1.8% 6.8% 11.8%
ROE 3.0% 11.3% 19.7%
Proposed Shares Outstanding = 240 shares
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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
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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 agency costs, no bankruptcy
costs
• No taxes
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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.

Our personal debt-equity ratio is: B $800 2

 
S $1,200 3
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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.
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M&M 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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M&M Proposition II (No Taxes)

• Proposition II:
• Leverage increases the risk and return to stockholders.

Rs = R0 + (B / S) (R0 - RB)
Rs is the return on (levered) equity (cost of equity)
R0 is the return on unlevered equity (cost of capital)
RB is the interest rate (cost of debt)
B is the value of debt
S (SL) is the value of levered equity
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Proof: M&M Proposition II (No Taxes)

The derivation is straightforward:
B S
RW ACC   RB   RS Then set RW ACC  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
 R B  RS  R0
S S
B B B
 RB  RS  R0  R0 RS  R0  ( R0  RB )
S S S
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M&M 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

B
Debt-to-equity Ratio
S
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M&M 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)
RS is the return on equity (cost of equity)
R0 is the return on unlevered equity (cost of capital)
RB is the interest rate (cost of debt)
B is the value of debt
S (SL) is the value of levered equity
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Proof: M&M 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
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Proof: M&M 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  BR B  VU R0  TC BR B
SRS  BR B  [ 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
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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)
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Total Cash Flow to Investors

Recession Expected Expansion
All Equity

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

Recession Expected
Expansion
EBIT $1,000 $2,000 $3,000
Levered

Interest ($8,000 @ 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
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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!
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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

• 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
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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?