Capital Structure: Part I

➢Does the financing mix of a firm matter?

➢Can we increase the value of the firm by
replacing its debt with equity? Or vice versa?
➢If yes, what determine the optimal capital
structure?
➢If no, why not?

1
 Outline
➢Review
➢The Pie Theory
➢EBIT-EPS analysis
➢The Modigliani-Miller model (M&M)
➢ Propositions I & II (no taxes)
➢ Propositions I & II (with corporate taxes)
➢The Miller model: personal taxes

2
 Review
➢All firms have to face business risk.
➢Operating leverage increases as fixed costs
rise and variable costs fall.
➢Operating leverage magnifies the effect of
business risk.
➢The degree of operating leverage is given by:
%Δ 𝑖𝑛 𝐸𝐵𝐼𝑇
𝐷𝑂𝐿 =
%Δ𝑖𝑛 𝑆𝑎𝑙𝑒𝑠

3
 Review
➢Financial leverage is the sensitivity of a firm’s
fixed costs of financing.
➢The degree of financial leverage is given by:

%Δ 𝑖𝑛 𝐸𝑃𝑆
𝐷𝐹𝐿 =
%Δ 𝑖𝑛 𝐸𝐵𝐼𝑇

➢Financial leverage always increases the equity

beta relative to the asset beta.

4
 Review
B S
rWACC = rB (1 − TC ) + rS
B+S B+S

 S =  A + ( A −  B ) (1 − TC )
B
S

➢A (the risk of the assets) is determined by

the business risk and the operating leverage.
➢S (the risk of the equity) increases when
B/S increases.
➢If assume B=0 and no tax, S = A (1 + B/S).
5
 The Pie Theory
The value of a firm is defined to be the sum of
the value of its debt and equity.
V=B+S
If the goal of the
management of the firm is to S B
make the firm as valuable as
possible, the firm should pick
the debt-equity ratio that
makes the pie as big as Value of the Firm
possible.
6
 Financial Leverage, EPS, and ROE
Consider an all-equity firm that is considering
going into debt. (Some of the original shareholders
want to cash out.) (NO TAXES)
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 15%
Shares outstanding 400 240
Share price $50 $50
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EPS and ROE Under Current Capital Structure

Recession Expected Expansion

EBIT $1,000 $3,000 $5,000
Interest 0 0 0
Net income $1,000 $3,000 $5,000
EPS $2.50 $7.50 $12.50
ROA 5% 15% 25%
ROE 5% 15% 25%

Current Shares Outstanding = 400 shares

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EPS and ROE Under Proposed Capital Structure

Recession Expected Expansion

EBIT $1,000 $3,000 $5,000
Interest 1,200 1,200 1,200
Net income -$200 $1,800 $3,800
EPS -$0.83 $7.50 $15.83
ROA 5% 15% 25%
ROE -1.7% 15% 31.7%

Current Shares Outstanding = 240 shares

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 Modigliani-Miller Model
➢Assumptions
➢ Homogeneous expectations
➢ Homogeneous business risk
➢ Perpetual cash flows
➢ Perfect capital markets
➢ Perfect competition
➢ Firms and individuals can borrow/lend at the same rate
➢ No transaction costs
➢ No taxes

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 Modigliani-Miller Model
Firm U Firm L

Current Current
Future CF Future CF
Value Value

Debt 0 0 rBB B
Equity EBIT SU EBIT-rBB SL

Total EBIT VU=SU EBIT VL=B+SL

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 Modigliani-Miller Model
No Debt, No Taxes

Current Liabilities
Current Assets

Cost of Goods Sold

VU
SU
Long-term Assets

R0

EBIT = NI

12
 Modigliani-Miller Model
With Debt, No Taxes

Current Liabilities
Current Assets

B Cost of Goods Sold

VL = VU

Long-term Assets
SL rB * B

WACC = R0

NI = EBIT - rB * B

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 Modigliani-Miller Model
Since future cash flows are the same for firms U
and L, VU = VL.

If VU > VL, investors earn arbitrage profits if

they, for example,
➢Buy 100% of SL, and Buy 100% of Firm L’s
debt, i.e. 100% of B
➢Short sell 100% of SU (VU = SU).
➢CF today = (VU - VL) > 0
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 Homemade Leverage
Recession Expected Expansion
EPS of Unlevered Firm $2.50 $7.50 $12.50

Earnings for 400 shares $1000 $3000 $5000

- interest on $8000 (15%) $1200 $1200 $1200
Net Profits -$200 $1800 $3800
ROE (Net Profits/$12000) -1.7% 15% 31.7%

Assume borrow $8000 (B) to buy 400 shares (100% of

unlevered equity). We get the same ROE as if we
bought into a levered firm.
Our personal debt equity ratio is: 8000/12000 = 2/3
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 Homemade (Un)Leverage
Recession Expected Expansion
EPS of Levered Firm -$0.83 $7.50 $15.83

Earnings for 240 shares -$200 $1800 $3800

+ interest on $8000 (15%) $1200 $1200 $1200
Net Profits $1000 $3000 $5000
ROE (Net Profits/$20000) 5% 15% 25%

Buying 240 shares (100%) of an otherwise identical

levered firm equity along with 100% 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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 The MM Propositions I & II (No Taxes)
➢ Proposition I
➢ Firm value is not affected by leverage
VL = VU
➢ Proposition II
➢ Leverage increases the risk and return to stockholders
rs = r0 + (B / S) (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 equity without
debt)
B is the value of debt
S is the value of levered equity
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 The MM Proposition II (No Taxes)
➢ From Proposition I (VU = VL), we know r0 = rWACC,
and
B S
rWACC = rB + rS
B+S B+S
➢ Therefore, setting
B S
r0 = rB + rS
B+S B+S
➢ Will give us Proposition II.

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MM Proposition II with No Taxes
Cost of capital: r (%)

B
rS = r0 + (r0 − rB )
SL

B S
r0 rWACC = rB + rS
B+S B+S

rB rB

Debt-to-equity Ratio
19
 Pie Theory with Corporate Taxes

All-equity firm Levered firm

G G

S B
S

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.
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 The MM Propositions I & II (with
Corporate Taxes)
➢Proposition I (with Corporate Taxes)
➢ Firm value increases with leverage
VL = VU + TC B
TC is the corporate tax rate

➢Proposition II (with Corporate Taxes)

➢ Some of the increase in equity risk and return is
offset by interest tax shield
rS = r0 + (B/S)(1-TC)(r0 - rB)
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 The MM Proposition I (Corp. Taxes)
➢The total cash flow to all stakeholders is
( EBIT − rB B)(1 − TC ) + rB B
= EBIT (1 − TC ) + TC rB B
➢The present value of this stream of cash flows
is VL.
➢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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 The MM Proposition II (Corp. Taxes)
➢ From Proposition I, we have
S + B = VU + TC B
➢ The cash flows from each side must equal:
SrS + BrB = VU r0 + TC BrB
SrS + BrB = [ S + B(1 − TC )]r0 + TC BrB
➢ Divide both side by S
B B B
rS + rB = [1 + (1 − TC )]r0 + TC rB
S S S
➢ Rearrange terms
B
rS = r0 + (1 − TC )(r0 − rB )
S
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MM Proposition II with Corp. Taxes
B
rS = r0 + (r0 − rB )
SL

B
rS = r0 + (1 − TC )(r0 − rB )
SL

r0

B SL
rWACC = rB (1 − TC ) + rS
B + SL B + SL
rB

Debt-to-equity
ratio (B/S)

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 Personal Taxes: The Miller Model
➢ The Miller Model shows that the value of a levered
firm can be expressed in terms of an unlevered firm
as:
 (1 − TC )(1 − TS ) 
VL = VU + 1 − B
 (1 − TB ) 
Where:
TS = personal tax rate on equity income
TB = personal tax rate on bond income
TC = corporate tax rate
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 Personal Taxes: The Miller Model
➢The derivation is straightforward:
➢ Shareholders in a levered firm receive
( EBIT − rB B)(1 − TC )(1 − TS )
➢ Bondholders receive
rB B(1 − TB )
➢The total cash flow to all stakeholders is
( EBIT − rB B)(1 − TC )(1 − TS ) + rB B(1 − TB )
➢This can be rewritten as
 (1 − TC )(1 − TS ) 
EBIT (1 − TC )(1 − TS ) + rB B(1 − TB ) 1 − 
 (1 − T B )  26
 Personal Taxes: The Miller Model
 (1 − TC )(1 − TS ) 
EBIT  (1 − TC )(1 − TS ) + rB B(1 − TB ) 1 − 
 (1 − TB ) 

The first term is the cash The after-tax discount rate is

flow of an unlevered firm rB(1- TB). Thus the value of the
after all taxes. second term is:
Its value = VU.  (1 − TC )(1 − TS ) 
B  1 − 
 (1 − TB ) 
 (1 − TC )(1 − TS ) 
VL = VU + 1 − B
 (1 − TB ) 
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 Personal Taxes: The Miller Model
 (1 − TC )(1 − TS ) 
VL = VU + 1 − B
 (1 − TB ) 
VL = VU+TCB when TS =TB
VL < VU + TCB
when TS < TB
but (1-TB) > (1-TC)(1-TS)
VU VL =VU
when (1-TB) = (1-TC)(1-TS)

VL < VU when (1-TB) < (1-TC)(1-TS)

Debt (B) 28
 Textbook Exercises

➢Chapter 16
➢ 8, 9, 14, 15, 19, 24

29