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15-1
Chapter Outline
CHAPTER
15
Capital Structure:
Basic Concepts
McGraw-Hill/Irwin
Corporate Finance, 7/e
15-2
15-3
S B
15-4
15-5
Current
Assets
$20,000
Debt
$0
Equity
$20,000
Debt/Equity ratio
0.00
Interest rate
n/a
Shares outstanding
400
Share price
$50
McGraw-Hill/Irwin
Corporate Finance, 7/e
Proposed
$20,000
$8,000
$12,000
2/3
8%
240
$50
Recession
$1,000
0
$1,000
$2.50
5%
5%
Expected Expansion
$2,000
$3,000
0
0
$2,000
$3,000
$5.00
$7.50
10%
15%
10%
15%
15-6
15-7
Recession
$1,000
640
$360
$1.50
5%
3%
All-Equity
Recession
EBIT
$1,000
Interest
0
Net income
$1,000
EPS
$2.50
ROA
5%
ROE
5%
Current Shares Outstanding = 400 shares
Expected Expansion
$2,000
$3,000
640
640
$1,360
$2,360
$5.67
$9.83
10%
15%
11%
20%
15-8
Expansion
$3,000
0
$3,000
$7.50
15%
15%
Expected
$2,000
640
$1,360
$5.67
10%
11%
Expansion
$3,000
640
$2,360
$9.83
15%
20%
Levered
Recession
EBIT
$1,000
Interest
640
Net income
$360
EPS
$1.50
ROA
5%
ROE
3%
Proposed Shares Outstanding = 240 shares
Expected
$2,000
0
$2,000
$5.00
10%
10%
McGraw-Hill/Irwin
Corporate Finance, 7/e
15-9
EPS
8.00
4.00
Homogeneous Expectations
Homogeneous Business Risk Classes
Perpetual Cash Flows
Perfect Capital Markets:
Debt
10.00
6.00
No Debt
Advantage
to debt
Break-even
point
Perfect competition
Firms and investors can borrow/lend at the same rate
Equal access to all relevant information
No transaction costs
No taxes
Disadvantage
to debt
2.00
0.00
1,000
(2.00)
McGraw-Hill/Irwin
Corporate Finance, 7/e
2,000
3,000
15-10
McGraw-Hill/Irwin
Corporate Finance, 7/e
15-11
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
McGraw-Hill/Irwin
Corporate Finance, 7/e
Bondholders receive
rB B
VL = VU
McGraw-Hill/Irwin
Corporate Finance, 7/e
15-12
15-13
The Cost of Equity, the Cost of Debt, and the Weighted Average
Cost of Capital: MM Proposition II with No Corporate Taxes
rWACC =
B
S
rB +
rS
B +S
B +S
B
S
rB +
rS = r0
B +S
B +S
B +S
B
B +S
S
B +S
rB +
rS =
r0
S
B +S
S
B +S
S
B
(r0 rB )
SL
B
S
rB +
rS
B+S
B+S
rWACC =
r0
B
B +S
rB + rS =
r0
S
S
rB
rB
B
B
rB + rS = r0 + r0
S
S
McGraw-Hill/Irwin
Corporate Finance, 7/e
rS = r0 +
rS = r0 +
B
(r0 rB )
S
15-14
Debt-to-equity Ratio S
McGraw-Hill/Irwin
Corporate Finance, 7/e
15-15
= EBIT (1 TC ) rB B (1 TC ) + rB B
rS = r0 + (B/S)(1-TC)(r0 - rB)
= EBIT (1 TC ) rB B + rB BTC + rB B
The present value of the first term is VU
VL = VU +TC B
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McGraw-Hill/Irwin
Corporate Finance, 7/e
15-17
VL = S + B
VL =VU +TC B
S + B =VU +TC B
rS = r0 +
VU = S + B (1 TC )
rS = r0 +
The cash flows from each side of the balance sheet must equal:
B
(r0 rB )
SL
B
(1 TC ) (r0 rB )
SL
r0
rWACC =
B
B
B
rB = [1 + (1 TC )]r0 + TC rB
S
S
S
B
rS = r0 + (1 TC ) (r0 rB )
Which quickly reduces to
S
rS +
McGraw-Hill/Irwin
Corporate Finance, 7/e
B
SL
rB (1 TC ) +
rS
B+SL
B + SL
rB
Debt-to-equity
ratio (B/S)
McGraw-Hill/Irwin
Corporate Finance, 7/e
15-18
15-19
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:
Levered firm
VL = VU
The sum of the debt plus the equity of the levered firm is
greater than the equity of the unlevered firm.
rS = r0 +
This is how cutting the pie differently can make the pie
larger: the government takes a smaller slice of the pie!
McGraw-Hill/Irwin
Corporate Finance, 7/e
15-20
McGraw-Hill/Irwin
Corporate Finance, 7/e
B
(r0 rB )
SL
15-21
Summary: Taxes
VL = VU + TC B
B
(1 TC ) (r0 rB )
SL
McGraw-Hill/Irwin
Corporate Finance, 7/e