Professional Documents
Culture Documents
McGraw-Hill/Irwin
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
16-1
Chapter Outline
16.1 The Capital Structure Question and The Pie Theory
16.2 Maximizing Firm Value versus Maximizing Stockholder Interests
16-2
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 firms 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.
S B
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 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.
16-4
Stockholder Interests
An example: Firm has 10,000 shares. Share price = $25. Debt has a market value of $100,000.
V = B + S = 100,000 + 10,000 * 25 = 350,000 Now suppose firm borrows another $50,000 and pays it immediately as a special dividend. B = 100,000 + 50,000 = 150,000 What would be shareholder gain/loss if firm value changes?
16-5
Example contd
Consider Three Possibilities:
V increases to $380,000
S Shareholder gain from dividend Capital loss $230,000 $50,000
V decreases to $320,000
170,000 $50,000
-$20,000
-$50,000
-80,000
Net gain/loss to $30,000 0 -30,000 shareholders Changes in capital structure benefit the stockholders if and only if the value
of the firm increases. Managers should choose the capital structure that they believe will have the highest firm value (to make the pie as big as possible).
16-6
Current Assets $20,000 Debt $0 Equity $20,000 Debt/Equity ratio 0.00 Interest rate n/a Shares outstanding 400 Share price $50
16-7
Break-even point
Advantage to debt
0.00
(2.00)
Disadvantage to debt
1,000
2,000
3,000
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
16-11
B $800 2 3 S $1,200
16-12
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
16-14
Proposition II
16-15
B S RB RS R0 BS BS
BS B BS S BS RB RS R0 S BS S BS S
B BS RB RS R0 S S
B B RB RS R0 R0 S S
B RS R0 ( R0 RB ) S
16-16
RS R0
B ( R0 RB ) SL
R0
RW ACC
B S RB RS BS BS
RB
RB
Debt-to-equity Ratio B S
16-17
Firm value increases with leverage VL = VU + TC B Some of the increase in equity risk and return is offset by the interest tax shield
RS = R0 + (B/S)(1-TC)(R0 - RB)
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
16-18
VL VU TC B
16-19
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:
RS R0 RS R0
B ( R0 RB ) SL
B (1 TC ) ( R0 RB ) SL
R0
RW ACC
B SL RB (1 TC ) RS BSL B SL
RB
16-21
EBIT Interest ($800 @ 8% ) EBT Taxes (Tc = 35%) Total Cash Flow (to both S/H & B/H): EBIT(1-Tc)+TCRBB
Levered
16-22
Levered firm
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!
16-23
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 I states that leverage increases the risk and return to stockholders.
B RS R0 ( R0 RB ) SL
16-24
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 Proposition II holds because The levered firm pays less in taxes than does the all-equity firm.. 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
16-25
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.
16-26
15-26
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? Problems # 16.1, 2, 3, 4, 6, 8, 10, 11
16-27