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Basic Concepts

Key Concepts and Skills

• 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

Chapter Outline

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

15.4 Modigliani and Miller: Proposition II (No

Taxes)

15.5 Taxes

15.1 Capital Structure and the Pie

• The value of a firm is defined to be the sum of the

value of the firm’s debt and the firm’s equity.

V=B+S

management is to make the S B

firm as valuable as possible,

then the firm should pick the

debt-equity ratio that makes

the pie as big as possible.

Value of the Firm

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 shareholder’s value?

benefit the stockholders if and only if the value

of the firm increases.

15.3 Financial Leverage, EPS, and ROE

Consider an all-equity firm that is contemplating going into

debt. (Maybe some of the original shareholders want to cash

out.)

Current Proposed

Assets $20,000 $20,000

Debt $0 $8,000

Equity $20,000 $12,000

Debt/Equity ratio 0.00 2/3

Interest rate n/a

8%

Shares outstanding 400

240

Share price $50

$50

EPS and ROE Under Current Structure

Recession Expected Expansion

EBIT $1,000 $2,000 $3,000

Interest 0 0 0

Net income $1,000 $2,000 $3,000

EPS $2.50 $5.00 $7.50

ROA 5% 10% 15%

ROE 5% 10% 15%

Current Shares Outstanding = 400 shares

EPS and ROE Under Proposed Structure

Recession Expected Expansion

EBIT $1,000 $2,000 $3,000

Interest 640 640 640

Net income $360 $1,360 $2,360

EPS $1.50 $5.67 $9.83

ROA 1.8% 6.8% 11.8%

ROE 3.0% 11.3% 19.7%

Proposed Shares Outstanding = 240 shares

Financial Leverage and EPS

12.00

10.00 Debt

8.00 No Debt

EPS

point to debt

4.00

2.00

0.00

1,000 2,000 3,000

(2.00) Disadvantage EBIT in dollars, no taxes

to debt

Assumptions of the M&M Model

• 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

Home Made Leverage

• Convert the payoff of unlevered firm to

levered firm

800 and invest your own funds of 1200.

• Leverage =800/1200 = 2/3

Homemade Leverage: An Example

RecessionExpected Expansion

EPS of Unlevered Firm$2.50 $5.00 $7.50

Earnings for 40 shares $100 $200 $300

Less interest on $800(8%)$64 $64 $64

Net Profits $36 $136 $236

ROE (Net Profits / $1,200) 3.0% 11.3% 19.7%

We are buying 40 shares of a $50 stock, using $800 in

margin. We get the same ROE as if we bought into a

levered firm.

B $ 800 2

Our personal debt-equity ratio is: S $ 1, 200 3

Home Made Unleverage

• Convert the payoff of levered firm to

unlevered firm

firm’s equity and $800 into the firm’s debt.

This represents a total investment of $2,000.

Homemade (Un)Leverage: An

Example

Recession Expected Expansion

EPS of Levered Firm $1.50 $5.67 $9.83

Earnings for 24 shares $36 $136 $236

Plus interest on $800 (8%) $64 $64 $64

Net Profits $100 $200 $300

ROE (Net Profits / $2,000) 5% 10% 15%

Buying 24 shares of an otherwise identical levered firm along

with some of the firm’s debt gets us to the ROE of the unlevered

firm.

This is the fundamental insight of M&M

MM Proposition I (No Taxes)

• 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

15.4 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

MM Proposition II (No Taxes)

The derivation is straightforward:

B S

RW ACC RB RS Then set RW A CC R 0

BS BS

B S BS

RB R S R0 multiply both sides by

BS BS S

BS B BS S BS

RB RS R0

S BS S BS S

B BS

RB RS R0

S S

B B B

R B R S R0 R0 R S R0 ( R0 R B )

S S S

MM Proposition II (No Taxes)

Cost of capital: R (%)

B

R S R0 ( R0 R B )

SL

B S

R0 RW ACC RB RS

BS BS

RB RB

Debt-to-equity Ratio B

S

15.5 MM Propositions I & II

(With Taxes)

– Firm value increases with leverage

VL = VU + TC B

• Proposition II (with Corporate Taxes)

– 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

MM Proposition I (With Taxes)

The total cash flow to all stakeholde rs is

( EBIT R B B ) (1 TC ) R B B

The present value of this stream of cash flows is VL

C learly ( E BIT R B B ) (1 T C ) R B B

E BIT (1 TC ) R B B (1 TC ) R B B

E BIT (1 TC ) R B B R B BT C R B B

The present value of the first term is VU

The present value of the second term is TCB

V L VU T C B

MM Proposition II (With Taxes)

Start with M&M Proposition I with taxes: V L VU T C B

Since V L S B S B VU TC B

VU S B (1 TC )

The cash flows from each side of the balance sheet must equal:

SR S BR B VU R 0 TC BR B

SR S BR B [ S B (1 TC )] R 0 TC R B B

Divide both sides by S

B B B

R S R B [1 (1 TC )] R0 TC R B

S S S

B

Which quickly reduces to R S R0 (1 TC ) ( R0 R B )

S

The Effect of Financial Leverage

Cost of capital: R B

(%) R S R0 ( R0 R B )

SL

B

R S R0 (1 TC ) ( R0 R B )

SL

R0

B SL

RW ACC R B (1 TC ) RS

BSL B SL

RB

Debt-to-equity

ratio (B/S)

Total Cash Flow to Investors

Recession Expected Expansion

EBIT $1,000 $2,000 $3,000

Interest 0 0 0

All Equity

Taxes (Tc = 35%) $350 $700 $1,050

EBIT $1,000 $2,000 $3,000

Interest ($800 @ 8% ) 640 640 640

Levered

Taxes (Tc = 35%) $126 $476 $826

Total Cash Flow $234+640 $884+$640 $1,534+$640

(to both S/H & B/H): $874 $1,524 $2,174

EBIT(1-Tc)+TCRBB $650+$224 $1,300+$224 $1,950+$224

$874 $1,524 $2,174

Total Cash Flow to Investors

All-equity firm Levered firm

S G 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!

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 II states that

leverage increases the risk and return to stockholders.

B

R S R0 ( R0 R B )

SL

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 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.

B

R S R0 (1 TC ) ( R0 R B )

SL

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?

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