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Chapter 16

Capital Structure: Basic Concepts

Instructor: Fan Yang

ACTSC 372
Winter 2015
2011 McGrawHill Ryerson Limited

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Chapter Outline
The Capital-Structure Question and The Pie Theory
The Impact of Financial Leverage on the
Firm Value
EPS
ROE

Modigliani and Miller (MM): Propositions I and II

No Taxes
With Taxes

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The Capital-Structure Question and The Pie Theory

Recall that the firms mix of securities is known as
its capital structure.
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
Three key questions:
What should the management do to
maximize shareholders interest?
Does a change in capital structure
affect the value of the firm?
Does it exist an optimal debt to equity
ratio (B/S) or debt to asset ratio (B/V )
that maximizes shareholders interest?

S B
S B

Value of the Firm

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Maximizing Firm Value versus Maximizing

Stockholder Interests
Management is appointed by the shareholders and
hence should attempt to maximize shareholders
interests
this in turn should maximize market values of
the equity

Maximizing Shareholders Interests

Maximizing Equity
Maximizing Firm Value

Since debt (interest) payments are fixed

shareholders only receive the residual cash flows
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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.)
Assets
Debt
Equity
Debt/Equity ratio
Interest rate
Shares outstanding
Share price

Current
$20,000
$0
$20,000
0.00
n/a
400
$50

Proposed
$20,000
$8,000
$12,000
2/3
8%
240
$50
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EPS and ROE Under Both Capital Structures

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

Expansion
$3,000
0
$3,000
$7.50
15%
15%

Expected
$2,000
640
$1,360
$5.67
10%
11.3%

Expansion
$3,000
640
$2,360
$9.83
15%
19.7%

Levered
EBIT
Interest
Net income
EPS
ROA
ROE

Recession
$1,000
640
$360
$1.50
5%
3.0%

Proposed Shares Outstanding = 240 shares

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Break-Even Analysis
12.00
Debt

10.00

EPS

8.00

No Debt

6.00
4.00

Advantage
to debt

Break-even
point

2.00
0.00
(2.00)

1,000

Disadvantage
to debt

2,000

3,000

EBIT
EBI in dollars, no taxes
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Break-Even Analysis (Cont.)

Is leverage always beneficial to the shareholders?
It depends on EBIT
EBIT > break-even point,
leverage increases EPS & ROE
EBIT < break-even point, leverage decreases
EPS & ROE
In any case, financial leverage increases the
volatility of EPS and ROE,
increases the risk of equity (higher slope)

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Modigliani and Miller (1958)

Assumptions:

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

Modigliani & Miller (MM) Proposition I (no taxes):

VL = VU
VU (VL) is the value of the unlevered (levered) firm
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Proof of MM Proposition I (No Taxes)

Consider Two firms: U and L, both with identical EBIT
Firm U is an unlevered firm, and firm L is a levered firm

Need to show a firm cannot change its total value by merely

changing the proportions of its capital structure
Key idea of the proof: Through homemade leverage,
individuals (or investors) can either duplicate or undo the
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effects of corporate leverage

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Proof of MM Proposition I (No Taxes) (cont.)

Consider the following two strategies:
Strategy X: Invest proportion of (by buying the
appropriate number of shares)
Strategy Y: Invest proportion of and borrow
proportion of . (The Homemade Leverage Portfolio)

We must have = to avoid arbitrage!

Homemade Leverage: investor can replicate the levered firm
by borrowing and taking appropriate position in unlevered firm
(and vice versa)
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Implications of MM Proposition I (No Taxes)

the value of the firm is independent of the

firms capital structure
capital structure is irrelevant

capital restructuring does not (in itself) create

value
Investment decision does not depend on the
source of funding
is constant for a given firm, regardless
of capital structure (no taxes)
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Required Return to Equity holders with Leveraging

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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

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MM Proposition II (No Taxes)

The derivation is straightforward:
rWACC

B
S
=
rB +
rS
B+S
B+S

B
S
rB +
rS = r0
B+S
B+S

Then set rWACC = r0

multiply both sides by

B+S
S

B+S
B
B+S
S
B+S

rB +

rS =
r0
S
B+S
S
S
B+S
B
B+S
rB + rS =
r0
S
S

B
B
rB + rS = r0 + r0
S
S

B
rS = r0 + (r0 rB )
S
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The Cost of Equity, the Cost of Debt, and the Weighted

Average Cost of Capital: MM Proposition II with No
Corporate Taxes
Cost of capital: r (%)

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r0

rS = r0 +

rWACC =

B
(r0 rB )
SL

B
S
rB +
rS
B+S
B+S

rB

rB

Debt-to-equity Ratio B
S
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What Determines the Cost of Capital?

MM argues that the firms overall cost of capital cannot be
reduced as debt is substituted for equity, even though debt
appears to be cheaper than equity
as firm adds debt, more projects are financed by lower-cost
debt
but the remaining equity becomes more risky, hence cost of
equity capital rises
MM proves that these two effects exactly offset each other!
return of equity compensates for two sources of risk:
business risk - equity risk that comes from the nature of the
firms operating activities (reflected in )
financial risk - extra risk from using debt financing

(measured by ( - ))

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An Example (No Taxes)

An all-equity firm has 10 million shares outstanding with
share price $20,
equity beta = 1.0
The firm plans to issue $50 million of 10% debt and use the
proceeds to pay a dividend to shareholders
Given = 6% and market risk premium of 8%
What is the effect of this capital restructuring on:
(a) the value of the firm,
(b) the
(c) the required return on equity
(d) the equity beta
(e) the wealth of the firms shareholders?

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Solution

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The MM Proposition I (Corp. Taxes)

Shareholders in a levered firm receive Bondholder s receive
( EBIT rB B) (1 TC )
rB B
Thus, 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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The MM Proposition II (Corp. Taxes)

Start with M&M Proposition I with taxes:
Since

VL = VU + TC B

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 + BrB = VU r0 + TC BrB

SrS + BrB = [ 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
Which quickly reduces to

B
rS = r0 + (1 TC ) (r0 rB )
S
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The Effect of Financial Leverage on the Cost of

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

rS = r0 +
rS = r0 +

B
(r0 rB )
SL

B
(1 TC ) (r0 rB )
SL

r0

rWACC =

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

Debt-to-equity
ratio (B/S)
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Total Cash Flow to Investors Under Each Capital

Structure with Corp. Taxes
All-Equity
EBIT
Interest
EBT
Taxes (Tc = 35%
Total Cash Flow to S/H

Recession
$1,000
0
$1,000
$350

Expected
$2,000
0
$2,000
$700

Expansion
$3,000
0
$3,000
$1,050

$650

$1,300

$1,950

Expected
$2,000
640
$1,360
$476
$468+$640
$1,524
$1,300+$224
$1,524

Expansion
$3,000
640
$2,360
$826
$1,534+$640
$2,174
$1,950+$224
$2,174

Levered
EBIT
Interest ($8000 @ 8% )
EBT
Taxes (Tc = 35%)
Total Cash Flow
(to both S/H & B/H):
EBIT(1-Tc)+TCrBB

Recession
$1,000
640
$360
$126
$234+640
$874
$650+$224
$874

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Total Cash Flow to Investors Under Each Capital

Structure with Corp. Taxes
All-equity firm
S

Levered firm
S

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: 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

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

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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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.

2011 McGrawHill Ryerson Limited