You are on page 1of 4

15-0

15-1

Chapter Outline
CHAPTER

15

15.1 The Capital-Structure Question and The Pie Theory


15.2 Maximizing Firm Value versus Maximizing
Stockholder Interests
15.3 Financial Leverage and Firm Value: An Example

Capital Structure:
Basic Concepts
McGraw-Hill/Irwin
Corporate Finance, 7/e

2005 The McGraw-Hill Companies, Inc. All Rights Reserved.

15-2

15.4 Modigliani and Miller: Proposition II (No Taxes)


15.5 Taxes
15.6 Summary and Conclusions
McGraw-Hill/Irwin
Corporate Finance, 7/e

2005 The McGraw-Hill Companies, Inc. All Rights Reserved.

15-3

The Capital-Structure Question


and The Pie Theory
The value of a firm is defined to be the sum of
the value of the firms debt and the firms equity.
V=B+S
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.
McGraw-Hill/Irwin
Corporate Finance, 7/e

S B

Value of the Firm

2005 The McGraw-Hill Companies, Inc. All Rights Reserved.

15-4

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
shareholders value?
As it turns out, changes in capital structure benefit the
stockholders if and only if the value of the firm
increases.
McGraw-Hill/Irwin
Corporate Finance, 7/e

2005 The McGraw-Hill Companies, Inc. All Rights Reserved.

15-5

Financial Leverage, EPS, and ROE


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

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

2005 The McGraw-Hill Companies, Inc. All Rights Reserved.

EPS and ROE Under Current Capital


Structure
EBIT
Interest
Net income
EPS
ROA
ROE

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%

Current Shares Outstanding = 400 shares


McGraw-Hill/Irwin
Corporate Finance, 7/e

2005 The McGraw-Hill Companies, Inc. All Rights Reserved.

15-6

15-7

EPS and ROE Under Both Capital Structures

EPS and ROE Under Proposed Capital


Structure
EBIT
Interest
Net income
EPS
ROA
ROE

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%

2005 The McGraw-Hill Companies, Inc. All Rights Reserved.

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

Proposed Shares Outstanding = 240 shares


McGraw-Hill/Irwin
Corporate Finance, 7/e

Expected
$2,000
0
$2,000
$5.00
10%
10%

McGraw-Hill/Irwin
Corporate Finance, 7/e

2005 The McGraw-Hill Companies, Inc. All Rights Reserved.

15-9

Financial Leverage and EPS


12.00

EPS

8.00

4.00

Homogeneous Expectations
Homogeneous Business Risk Classes
Perpetual Cash Flows
Perfect Capital Markets:

Debt

10.00

6.00

Assumptions of the Modigliani-Miller


Model

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

EBIT in dollars, no taxes


2005 The McGraw-Hill Companies, Inc. All Rights Reserved.

15-10

McGraw-Hill/Irwin
Corporate Finance, 7/e

2005 The McGraw-Hill Companies, Inc. All Rights Reserved.

15-11

The MM Propositions I & II (No Taxes)


Proposition I
Firm value is not affected by leverage
VL = VU

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

2005 The McGraw-Hill Companies, Inc. All Rights Reserved.

The MM Proposition I (No Taxes)


The derivation is straightforward:
Shareholders in a levered firm receive
EBIT rB B

Bondholders receive
rB B

Thus, the total cash flow to all stakeholders is


( EBIT rB B ) + rB B
The present value of this stream of cash flows is VL
Clearly
( EBIT rB B) + rB B = EBIT
The present value of this stream of cash flows is VU

VL = VU

McGraw-Hill/Irwin
Corporate Finance, 7/e

2005 The McGraw-Hill Companies, Inc. All Rights Reserved.

15-12

15-13

The MM Proposition II (No Taxes)

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

Cost of capital: r (%)

The derivation is straightforward:


Then set rWACC = r0
B +S
multiply both sides by
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

2005 The McGraw-Hill Companies, Inc. All Rights Reserved.

15-14

Debt-to-equity Ratio S
McGraw-Hill/Irwin
Corporate Finance, 7/e

2005 The McGraw-Hill Companies, Inc. All Rights Reserved.

15-15

The MM Proposition I (Corp. Taxes)

The MM Propositions I & II


(with Corporate Taxes)

Shareholders in a levered firm receive Bondholders receive


( EBIT rB B) (1 TC )
rB B
Thus, the total cash flow to all stakeholders is
( EBIT rB B ) (1 TC ) + rB B

Proposition I (with Corporate Taxes)


Firm value increases with leverage
VL = VU + TC B

Proposition II (with Corporate Taxes)

The present value of this stream of cash flows is VL


Clearly ( EBIT rB B ) (1 TC ) + rB B =

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


interest tax shield

= 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

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
McGraw-Hill/Irwin
Corporate Finance, 7/e

VL = VU +TC B

The present value of the second term is TCB

2005 The McGraw-Hill Companies, Inc. All Rights Reserved.

15-16

McGraw-Hill/Irwin
Corporate Finance, 7/e

2005 The McGraw-Hill Companies, Inc. All Rights Reserved.

15-17

The MM Proposition II (Corp. Taxes)


Start with M&M Proposition I with taxes:
Since

VL = S + B

VL =VU +TC B

S + B =VU +TC B

The Effect of Financial Leverage on the Cost of Debt and


Equity Capital with Corporate Taxes
Cost of capital: r
(%)

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

SrS + BrB = VU r0 +TC BrB


SrS + BrB = [ S + B(1 TC )]r0 +TC rB B
Divide both sides by S

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

2005 The McGraw-Hill Companies, Inc. All Rights Reserved.

B
SL
rB (1 TC ) +
rS
B+SL
B + SL
rB

Debt-to-equity
ratio (B/S)
McGraw-Hill/Irwin
Corporate Finance, 7/e

2005 The McGraw-Hill Companies, Inc. All Rights Reserved.

15-18

15-19

Total Cash Flow to Investors Under


Each Capital Structure with Corp. Taxes
All-equity firm
S

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

Prop 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

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

2005 The McGraw-Hill Companies, Inc. All Rights Reserved.

15-20

McGraw-Hill/Irwin
Corporate Finance, 7/e

B
(r0 rB )
SL

2005 The McGraw-Hill Companies, Inc. All Rights Reserved.

15-21

Summary: Taxes

Prospectus: Bankruptcy Costs

In a world of taxes, but no bankruptcy costs, the value


of the firm increases with leverage.
This is M&M Proposition I:

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.

VL = VU + TC B

Prop 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.
rS = r0 +
McGraw-Hill/Irwin
Corporate Finance, 7/e

B
(1 TC ) (r0 rB )
SL

2005 The McGraw-Hill Companies, Inc. All Rights Reserved.

McGraw-Hill/Irwin
Corporate Finance, 7/e

2005 The McGraw-Hill Companies, Inc. All Rights Reserved.

You might also like