Capital Structure: Basic

Concepts
Chapter 16

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McGraw-Hill/Irwin Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved.
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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
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Outline
• The Capital Structure Question and The Pie Theory

• Maximizing Firm Value versus Maximizing Stockholders’

Value

• Financial Leverage and Firm Value: An Example

• Modigliani and Miller (M&M) Propositions I and II (No

Taxes)

• Modigliani and Miller (M&M) Propositions I and II (With

Taxes)
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Capital Structure and the Pie

Equity (shareholders' stack)= Total asset - liability
• 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
B: Debt
S: Equity
• If the goal of the firm’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
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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 shareholders’ value.
2. What is the ratio of debt-to-equity that maximizes the
shareholders’ value?

As it turns out, changes in capital structure only benefit

the stockholders if the value of the firm increases.
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Financial Leverage, EPS, and ROE

assume no tax
Consider an all-equity firm that is contemplating going
into debt. (Maybe some of the original shareholders
want to cash out.)
no debt (use all-equity) with debt
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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EPS and ROE Under Current Capital Structure

assume no tax so Net income = EBIT (earning before tax)- interest = EBIT

Recession Expected Expansion

EBIT $1,000 $2,000 $3,000
Interest 0 0 0
Net income $1,000 $2,000 $3,000
EPS 1000/400 $2.50 $5.00 $7.50
ROA 1000/20000 5% 10% 15%
ROE 5% 10% 15%
Current Shares Outstanding = 400 shares
EPS = net income / current share outstanding
ROA = net income / total asset
ROE = net income / total equity
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EPS and ROE Under Proposed Capital Structure

same but use number in 'proposed' column
borrow 8000 x 8% (debt i-rate)

Recession Expected Expansion

EBIT $1,000 $2,000 $3,000
Interest 8000*8% 640 640 640
Net income $360 $1,360 $2,360
EPS 360/240 $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
if economy in Rescession, company should
not use 'Proposed CS' since lower EPS
than current one 1.5<2.5
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Financial Leverage and EPS

12.00 check 'note' to find B-even point

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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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 agency costs, no bankruptcy
costs
• No taxes
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Homemade Leverage: An Example

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:  
S $1,200 3
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Homemade (Un)Leverage: An Example

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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M&M 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
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M&M Proposition II (No Taxes)

• Proposition II:
• Leverage increases the risk and return to stockholders.

Rs = R0 + (B / S) (R0 - RB)
Rs is the return on (levered) equity (cost of equity)
R0 is the return on unlevered equity (cost of capital)
RB is the interest rate (cost of debt)
B is the value of debt
S (SL) is the value of levered equity
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Proof: M&M Proposition II (No Taxes)

The derivation is straightforward:
B S
RW ACC   RB   RS Then set RW ACC  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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M&M Proposition II (No Taxes)

Cost of capital: R (%)

B
RS  R0   ( R0  RB )
SL

B S
R0 RW ACC   RB   RS
BS BS

RB RB

B
Debt-to-equity Ratio
S
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M&M Propositions I & II (With Taxes)

• 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)
RS is the return on equity (cost of equity)
R0 is the return on unlevered equity (cost of capital)
RB is the interest rate (cost of debt)
B is the value of debt
S (SL) is the value of levered equity
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Proof: M&M Proposition I (With Taxes)

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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Proof: M&M Proposition II (With Taxes)

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  BR B  VU R0  TC BR B
SRS  BR B  [ 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
B
Which quickly reduces to RS  R0   (1  TC )  ( R0  RB )
S
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The Effect of Financial Leverage

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)
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Total Cash Flow to Investors

Recession Expected Expansion
All Equity

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

Interest 0 0 0
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
Levered

Interest ($800 @ 8% ) 640 640 640

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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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!
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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
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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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?