Chapter 16

Capital Structure: Basic Concepts

 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

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16-1
16.1 The Capital Structure Question and The Pie Theory
16.2 Maximizing Firm Value versus Maximizing
Stockholder Interests
16.3 Financial Leverage and Firm Value: An Example
16.4 Modigliani and Miller: Proposition II (No Taxes)
16.5 Taxes

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16-2
 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

• If the goal of the firm’s

management is to make the firm
as valuable as possible, then the S B
firm should pick the debt-equity
ratio that makes the pie as big as
possible.

Value of the Firm

16-3
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?

As it turns out, changes in capital structure only benefit

the stockholders if the value of the firm increases.

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16-4
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

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 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

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16-6
 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

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16-7
 12.00

10.00 Debt

8.00 No Debt

6.00 Break-even Advantage

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
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16-8
 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

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16-9
 Recession Expected 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:   3
S $1,200

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 RecessionExpected 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

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16-11
 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

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16-12
 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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16-13
 The derivation is straightforward:
B S
RWACC   RB   RS Then set RWACC  R0
BS BS
B S BS
 RB   RS  R0 multiply both sides by
BS BS S
 BS B B  S S BS
  RB    RS  R0
S BS S BS S
B B
S
 RB  RS  R0
S S
B B B
 RB  RS  R0  R0 RS  R0  (R0  RB )
S S S

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Cost of capital: R (%)

B
RS  R0   ( R0  RB )
SL

B S
R0 RW ACC   RB   RS
BS BS

RB RB

Debt-to-equity Ratio
B
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16-15
 Proposition I (with Corporate 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

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16-16
The total cash flow to all stakeholders 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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 Start with M&M Proposition I with taxes: VL  VU  TC B
Since 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
both sides by S
Divide
 RS  B RB  [1 B (1  TC )]R0  B TC RB
S S S
 B
Which quickly reduces to RS  R0   (1  TC )  (R0  RB )
S
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Cost of capital: R B
(%) RS  R0   ( R0  RB )
SL

B
RS  R0   (1  TC )  ( R0  RB )
SL

R0

B SL
RW ACC   RB  (1  TC )   RS
BSL B  SL
RB

Debt-to-equity
ratio (B/S)

16-19
 Recession Expected Expansion
EBIT $1,000 $2,000 $3,000
Interest 0 0 0
All Equity

EBT $1,000 $2,000 $3,000

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

Total Cash Flow to S/H $650 $1,300 $1,950

Recession Expected Expansion

EBIT $1,000 $2,000 $3,000
Interest ($800 @ 8% ) 640 640 640
Levered

EBT $360 $1,360 $2,360

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
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 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!

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16-21
 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
RS  R0   (R0  RB )
SL

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16-22
 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
RS  R0   (1  TC )  (R0  RB )
SL

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16-23
 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?

16-24