Capital Structure Decisions: Extensions

17 - 1
CHAPTER 17
Capital Structure Decisions:
Extensions
 MM and Miller models

 Hamada’s equation
 Financial distress and agency costs
 Trade-off models
 Asymmetric information theory
Copyright © 2002 by Harcourt Inc. All rights reserved.
17 - 2
Who are Modigliani and Miller (MM)?
 They published theoretical papers

that changed the way people thought
about financial leverage.
 They won Nobel prizes in economics
because of their work.
 MM’s papers were published in 1958
and 1963. Miller had a separate
paper in 1977. The papers differed in
their assumptions about taxes.
17 - 3
What assumptions underlie the MM

and Miller models?
 Firms can be grouped into

homogeneous classes based on
business risk.
 Investors have identical
expectations about firms’ future
earnings.
 There are no transactions costs.
(More...)
17 - 4
 All debt is riskless, and both

individuals and corporations can
borrow unlimited amounts of money
at the risk-free rate.
 All cash flows are perpetuities. This
implies perpetual debt is issued,
firms have zero growth, and
expected EBIT is constant over time.
(More...)
17 - 5
 MM’s first paper (1958) assumed

zero taxes. Later papers added
taxes.
 No agency or financial distress
costs.
 These assumptions were necessary
for MM to prove their propositions
on the basis of investor arbitrage.

17 - 6
MM with Zero Taxes (1958)
Proposition I:
VL = VU.
Proposition II:
ksL = ksU + (ksU - kd)(D/S).

17 - 7
Given the following data, find V, S,

ks, and WACC for Firms U and L.
Firms U and L are in same risk class.

EBITU,L = $500,000.
Firm U has no debt; ksU = 14%.
Firm L has $1,000,000 debt at kd = 8%.
The basic MM assumptions hold.
There are no corporate or personal taxes.
17 - 8
1. Find VU and VL.
EBIT $500,000
VU = = = $3,571,429.
ksU 0.14
VL = VU = $3,571,429.
Questions: What is the derivation of

the VU equation? Are the MM
assumptions required?
17 - 9
2. Find the market value of

Firm L’s debt and equity.
VL = D + S = $3,571,429
$3,571,429 = $1,000,000 + S
S = $2,571,429.

17 - 10
3. Find ksL.
ksL = ksU + (ksU - kd)(D/S)

$1,000,000
= 14.0% + (14.0% - 8.0%) $2,571,429 ( )
= 14.0% + 2.33% = 16.33%.

17 - 11
4. Proposition I implies WACC = ksU.

Verify for L using WACC formula.
WACC = wdkd + wceks = (D/V)kd + (S/V)ks

$1,000,000
(
= $3,571,429 (8.0%) )
+($3,571,429)(16.33%)
$2,571,429
= 2.24% + 11.76% = 14.00%.

17 - 12
Graph the MM relationships between

capital costs and leverage as measured
by D/V.
Cost of Without taxes
Capital (%)
26 ks
20
14 WACC
kd
8
Debt/Value
0 20 40 60 80 100 Ratio (%)
17 - 13
 The more debt the firm adds to its

capital structure, the riskier the
equity becomes and thus the higher
its cost.
 Although kd remains constant, ks
increases with leverage. The
increase in ks is exactly sufficient to
keep the WACC constant.

17 - 14
Graph value versus leverage.

Value of Firm, V (%)
4
VU VL
3
Firm value ($3.6 million)
2
1
0 0.5 1.0 1.5 2.0 2.5
Debt (millions of $)
With zero taxes, MM argue that value
is unaffected by leverage.
17 - 15
Find V, S, ks, and WACC for Firms U

and L assuming a 40% corporate
tax rate.
With corporate taxes added, the MM
propositions become:
Proposition I:
VL = VU + TD.
Proposition II:
ksL = ksU + (ksU - kd)(1 - T)(D/S).
17 - 16
Notes About the New Propositions
1. When corporate taxes are added,

VL ≠ VU. VL increases as debt is
added to the capital structure, and
the greater the debt usage, the
higher the value of the firm.
2. ksL increases with leverage at a
slower rate when corporate taxes
are considered.
17 - 17
1. Find VU and VL.
VU =
EBIT(1 - T) =
$500,000(0.6) = $2,142,857.
ksU 0.14
Note: Represents a 40% decline from the no

taxes situation.
VL = VU + TD = $2,142,857 + 0.4($1,000,000)
= $2,142,857 + $400,000
= $2,542,857.
17 - 18
2. Find market value of Firm

L’s debt and equity.
VL = D + S = $2,542,857
$2,542,857 = $1,000,000 + S
S = $1,542,857.

17 - 19
3. Find ksL.
ksL = ksU + (ksU - kd)(1 - T)(D/S)

$1,000,000
= 14.0% + (14.0% - 8.0%)(0.6) $1,542,857 ( )
= 14.0% + 2.33% = 16.33%.

17 - 20
4. Find Firm L’s WACC.
WACCL = (D/V)kd(1 - T) + (S/V)ks

$1,000,000
(
= $2,542,857 (8.0%)(0.6) )
$1,542,857
(
+ $2,542,857 (16.33%) )
= 1.89% + 9.91% = 11.80%.
When corporate taxes are considered, the
WACC is lower for L than for U.
17 - 21
MM relationship between capital costs

and leverage when corporate taxes are
considered.
Cost of
Capital (%)
ks
26
20
14
WACC
8 kd(1 - T)
Debt/Value
0 20 40 60 80 100 Ratio (%)
17 - 22
MM relationship between value and debt

when corporate taxes are considered.
Value of Firm, V (%)
4
VL
3 TD
2 VU
1 Debt
0 0.5 1.0 1.5 2.0 2.5 (Millions of $)
Under MM with corporate taxes, the firm’s value

increases continuously as more and more debt is used.
17 - 23
Assume investors have the following

tax rates: Td = 30% and Ts = 12%. What
is the gain from leverage according to
the Miller model?
Miller’s Proposition I:
VL = VU + 1 - [
(1 - Tc)(1 - Ts)
(1 - Td) D. ]
Tc = corporate tax rate.
Td = personal tax rate on debt income.
Ts = personal tax rate on stock income.
17 - 24
Tc = 40%, Td = 30%, and Ts = 12%.
(1 - 0.40)(1 - 0.12)
VL = V U + 1 - [
(1 - 0.30) ]
D
= VU + (1 - 0.75)D
= VU + 0.25D.
Value rises with debt; each $100 increase

in debt raises L’s value by $25.
17 - 25
How does this gain compare to the gain

in the MM model with corporate taxes?
If only corporate taxes, then

VL = VU + TcD = VU + 0.40D.
Here $100 of debt raises value by

$40. Thus, personal taxes lowers the
gain from leverage, but the net effect
depends on tax rates.
(More...)
17 - 26
 If Ts declines, while Tc and Td remain

constant, the slope coefficient
(which shows the benefit of debt) is
decreased.
 A company with a low payout ratio
gets lower benefits under the Miller
model than a company with a high
payout, because a low payout
decreases Ts.

17 - 27
When Miller brought in personal

taxes, the value enhancement of debt
was lowered. Why?
1. Corporate tax laws favor debt over

equity financing because interest
expense is tax deductible while
dividends are not.
(More...)
17 - 28
2. However, personal tax laws favor

equity over debt because stocks
provide both tax deferral and a
lower capital gains tax rate.
3. This lowers the relative cost of
equity vis-a-vis MM’s no-personal-
tax world and decreases the spread
between debt and equity costs.
4. Thus, some of the advantage of debt
financing is lost, so debt financing
is less valuable to firms.
17 - 29
What does capital structure theory

prescribe for corporate managers?
1. MM, No Taxes: Capital structure is

irrelevant--no impact on value or WACC.
2. MM, Corporate Taxes: Value increases,
so firms should use (almost) 100% debt
financing.
3. Miller, Personal Taxes: Value increases,
but less than under MM, so again firms
should use (almost) 100% debt financing.
17 - 30
Do firms follow the recommendations

of capital structure theory?
 Firms don’t follow MM/Miller to 100%

debt. Debt ratios average about 40%.
 However, debt ratios did increase
after MM. Many think debt ratios
were too low, and MM led to changes
in financial policies.

17 - 31
Define financial distress and

agency costs.
Financial distress: As firms use

more and more debt financing, they
face a higher probability of future
financial distress, which brings with
it lower sales, EBIT, and bankruptcy
costs. Lowers value of stock and
bonds.
(More...)
17 - 32
Agency costs: The costs of

managers not behaving in the best
interests of shareholders and the
resulting costs of monitoring
managers’ actions. Lowers value of
stock and bonds.

17 - 33
How do financial distress and agency

costs change the MM and Miller
models?
 MM/Miller ignored these costs, hence

those models show firm value
increasing continuously with
leverage.
 Since financial distress and agency
costs increase with leverage, such
costs reduce the value of debt
financing.
17 - 34
Here’s a valuation model which

includes financial distress and
agency costs:
PV of expected PV of agency
VL = VU + XD - - costs .
fin. distress costs
 X represents either Tc in the MM model
or the more complex Miller term.
 Now, optimal leverage involves a
tradeoff between the tax benefits of
debt and the costs associated with
financial distress and agency.
17 - 35
Relationships between capital costs

and leverage when financial distress
and agency costs are considered.
Cost of Capital (%)
ks
14 WACC
kd(1 - T)
4
D* Debt ($)
17 - 36
Relationship between value and

leverage.
Note that value is

Value of Firm ($)
maximized and WACC is
minimized at the same
4 capital structure.
3
2
1
D* Debt ($)
17 - 37
How are financial and business risk

measured in a market risk framework?
ksL = kRF + (kM - kRF)bU

+ (kM - kRF)bU(1 - T)(D/S)
Pure Business Financial
time risk risk
= value + premium + premium .
(Hamada’s equation)
17 - 38
Hamada’s equation for beta:
bL = bU + bU(1 - T)(D/S)
Unlevered Increased
beta, which volatility of
= reflects the + the returns
business to equity
risk of the due to the
firm use of debt
Business Financial
= + .
risk risk
17 - 39
What is the “pecking order theory”

of capital structure?
 Results of a survey by Donaldson and

the asymmetric information theory.
 Firms follow a specific financing order:
First use internal funds.
Next, draw on marketable securities.
Then, issue new debt.
Finally, and only as a last resort, issue new
common stock.
17 - 40
Does the pecking order theory make

sense? Explain.
Is the pecking order theory consistent
with the trade-off theory?
 It is consistent with the

asymmetric information theory, in
which managers avoid issuing
equity.
 It is not consistent with trade-off
theory.
17 - 41
What is the asymmetric information

theory of capital structure?
 Theory recognizes that market

participants do not have
homogeneous expectations--
managers typically have better
information than investors.
 Thus, financing actions are
interpreted by investors as
signals of managerial
expectations for the future. (More...)
17 - 42
 Managers will issue new common

stock only when no other
alternatives exist or when the stock
is overvalued.
 Investors recognize this, so new
stock sales are treated as negative
signals and stock price falls.
 Managers do not want to trigger a
price decline, so firms maintain a
reserve borrowing capacity.

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17 - 1

 MM and Miller models

Who are Modigliani and Miller (MM)?

 They published theoretical papers

What assumptions underlie the MM

 Firms can be grouped into

 All debt is riskless, and both

 MM’s first paper (1958) assumed

Copyright © 2002 by Harcourt Inc. All rights reserved.

MM with Zero Taxes (1958)

Copyright © 2002 by Harcourt Inc. All rights reserved.

Given the following data, find V, S,

Firms U and L are in same risk class.

1. Find VU and VL.

Questions: What is the derivation of

2. Find the market value of

Copyright © 2002 by Harcourt Inc. All rights reserved.

ksL = ksU + (ksU - kd)(D/S)

Copyright © 2002 by Harcourt Inc. All rights reserved.

4. Proposition I implies WACC = ksU.

WACC = wdkd + wceks = (D/V)kd + (S/V)ks

= 2.24% + 11.76% = 14.00%.

Graph the MM relationships between

 The more debt the firm adds to its

Copyright © 2002 by Harcourt Inc. All rights reserved.

Graph value versus leverage.

Find V, S, ks, and WACC for Firms U

Notes About the New Propositions

1. When corporate taxes are added,

1. Find VU and VL.

Note: Represents a 40% decline from the no

2. Find market value of Firm

Copyright © 2002 by Harcourt Inc. All rights reserved.

ksL = ksU + (ksU - kd)(1 - T)(D/S)

Copyright © 2002 by Harcourt Inc. All rights reserved.

4. Find Firm L’s WACC.

WACCL = (D/V)kd(1 - T) + (S/V)ks

MM relationship between capital costs

MM relationship between value and debt

Under MM with corporate taxes, the firm’s value

Assume investors have the following

Tc = 40%, Td = 30%, and Ts = 12%.

Value rises with debt; each $100 increase

How does this gain compare to the gain

If only corporate taxes, then

Here $100 of debt raises value by

 If Ts declines, while Tc and Td remain

Copyright © 2002 by Harcourt Inc. All rights reserved.

When Miller brought in personal

1. Corporate tax laws favor debt over

2. However, personal tax laws favor

What does capital structure theory

1. MM, No Taxes: Capital structure is

Do firms follow the recommendations

 Firms don’t follow MM/Miller to 100%

Copyright © 2002 by Harcourt Inc. All rights reserved.

Define financial distress and

Financial distress: As firms use

Agency costs: The costs of

Copyright © 2002 by Harcourt Inc. All rights reserved.

How do financial distress and agency

 MM/Miller ignored these costs, hence