Corporate Finance

Capital Structure: Basics

Yuanyuan Xiao
Table of contents

1. The Capital Structure Question and The Pie Theory

2. Financial Leverage and Firm Value: An Example

3. Modigliani and Miller: Proposition II (No Taxes)

4. Taxes and M&M with Corp Taxes

5. Stock Prices and Leverage Under Corporate Taxes

1
The Capital Structure Question
and The Pie Theory
Capital Structure and the Pie

The value of a firm is defined to be the

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

V=B+S

2
Capital Structure and the Pie

The value of a firm is defined to be the

sum of the market 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 firm should pick the debt-equity ratio that makes
the pie as big as possible.

2
Stockholder Interests

There are two important questions:

3
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?

3
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?

3
Stockholder Interests

Important question 1: Max firm value vs. Max stockholder interest

4
Stockholder Interests

Important question 1: Max firm value vs. Max stockholder interest

When a firm is liquidated, bondholders get paid first. After that, if

there remains any positive cash, shareholder will be paid.

4
Stockholder Interests

Important question 1: Max firm value vs. Max stockholder interest

When a firm is liquidated, bondholders get paid first. After that, if

there remains any positive cash, shareholder will be paid.

Therefore, what matters for bondholders is the credibility of the firm.

On the other hand, firm value is of great concern of shareholders.

4
Stockholder Interests

Important question 1: Max firm value vs. Max stockholder interest

When a firm is liquidated, bondholders get paid first. After that, if

there remains any positive cash, shareholder will be paid.

Therefore, what matters for bondholders is the credibility of the firm.

On the other hand, firm value is of great concern of shareholders.

Managers should choose the capital structure that maximizes the

firm value because it is the capital structure that will primarily ben-
efit stockholders.

4
Financial Leverage and Firm
Value: An Example
Financial Leverage, EPS, and ROE

Important question 2: What is the optimal capital structure that max-

imizes stockholder wealth?

5
Financial Leverage, EPS, and ROE

Important question 2: What is the optimal capital structure that max-

imizes stockholder wealth?

Consider the impact of financial leverage on

• earnings-per-share (EPS)
• return-to-equity (ROE)

5
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.)

6
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.)

The firm borrows $8,000 and buys back 160 shares at $50 per share.

* For simplicity, stock price is assumed to be unchanged.

6
EPS and ROE under Current Structure

Current Shares Outstanding = 400 shares

ROA = ROE in the absence of debt, since assets = equity

7
EPS and ROE under Proposed Structure

Proposed Shares Outstanding = 240 shares

ROA < ROE in the presence of debt, since assets > equity

8
Financial Leverage, EPS, and ROE

9
Financial Leverage, EPS, and ROE

Relative to the current all-equity structure, with the presence of debt,

ROE and EPS are

• lower in recessions
• higher in expansions

9
Financial Leverage and EPS

10
Financial Leverage and EPS

Advantage of debt: Financial leverage is beneficial in expansions.

Disadvantage of debt: Financial leverage creates risk in recessions.

10
The Choice Between Debt and Equity

Which capital structure is better?

11
The Choice Between Debt and Equity

Which capital structure is better?

• Financial leverage magnifies profits in expansion

• Financial leverage intensities losses in recession

11
The Choice Between Debt and Equity

Which capital structure is better?

• Financial leverage magnifies profits in expansion

• Financial leverage intensities losses in recession

Modgigliani and Miller (M&M) Proposition I (no taxes): a firm cannot

change the total value of its outstanding securities by changing the
proportions of its capital structure.

11
The Choice Between Debt and Equity

Which capital structure is better?

• Financial leverage magnifies profits in expansion

• Financial leverage intensities losses in recession

Modgigliani and Miller (M&M) Proposition I (no taxes): a firm cannot

change the total value of its outstanding securities by changing the
proportions of its capital structure.

In other words, no capital structure is better or worse than any other

capital structure for the firms’ shareholders without taxes.

11
Assumptions of the M&M Model (No Taxes)

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

12
Homemade Leverage: An Example

Recall the basics on the unlevered and levered firms

13
Homemade Leverage: An Example

Recall the basics on the unlevered and levered firms

Compare returns on the following two strategies:

1. Buy 40 shares of the levered firm

13
Homemade Leverage: An Example

Recall the basics on the unlevered and levered firms

Compare returns on the following two strategies:

1. Buy 40 shares of the levered firm

2. Borrow $800 at 8%, use the borrowed proceeds plus our own
$1,200 to buy 40 shares of the unlevered firm

13
Homemade Leverage: An Example

14
Homemade Leverage: An Example

Our initial costs is $2,000 - 800 = $1,200: We are buying 40 shares of a

$50 stock, with $800 borrowed.

14
Homemade Leverage: An Example

Our initial costs is $2,000 - 800 = $1,200: We are buying 40 shares of a

$50 stock, with $800 borrowed.
We get the same return as if we bought into a levered firm.

14
Homemade Leverage: An Example

Our initial costs is $2,000 - 800 = $1,200: We are buying 40 shares of a

$50 stock, with $800 borrowed.
We get the same return as if we bought into a levered firm.
Our personal debt-to-equity ratio is:
B $800
= = 2/3 → the same as the levered firm
S $1, 200

14
Homemade (Un)Leverage: An Example

Recall the basics on the unlevered and levered firms

15
Homemade (Un)Leverage: An Example

Recall the basics on the unlevered and levered firms

Compare returns on the following two strategies:

1. Buy 24 shares of the unlevered firm

15
Homemade (Un)Leverage: An Example

Recall the basics on the unlevered and levered firms

Compare returns on the following two strategies:

1. Buy 24 shares of the unlevered firm

2. Buy 24 shares of the levered firm and invest $800 into the firm’s
debt at 8%

15
Homemade (Un)Leverage: An Example

16
Homemade (Un)Leverage: An Example

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.

16
M&M Proposition I (No Taxes)

We can create a levered or unlevered position by adjusting the trading

in our own account.

17
M&M Proposition I (No Taxes)

We can create a levered or unlevered position by adjusting the trading

in our own account.

An investor is not receiving anything from corporate leverage that she

could not receive on her own.

17
M&M Proposition I (No Taxes)

We can create a levered or unlevered position by adjusting the trading

in our own account.

An investor is not receiving anything from corporate leverage that she

could not receive on her own.

A firm would neither help or hurt its stockholders by restructuring.

17
M&M Proposition I (No Taxes)

We can create a levered or unlevered position by adjusting the trading

in our own account.

An investor is not receiving anything from corporate leverage that she

could not receive on her own.

A firm would neither help or hurt its stockholders by restructuring.

This homemade leverage/unleverage suggests that capital structure

is irrelevant in determining the value of the firm:

VU = VL

17
Modigliani and Miller:
Proposition II (No Taxes)
Implication of M&M I (No Taxes): WACC

Weighted average cost of capital

S B
RWACC = × RS + × RB
S+B S+B

18
Implication of M&M I (No Taxes): WACC

Weighted average cost of capital

S B
RWACC = × RS + × RB
S+B S+B

Recall the example of levered and unlevered firms

$0 $20, 000
Unlevered firm: RWACC = × 8% + × 10% = 10%
$20, 000 $20, 000

$8, 000 $12, 000

Unlevered firm: RWACC = × 8% + × 11.3% = 10%
$20, 000 $20, 000

18
Implication of M&M I (No Taxes): WACC

Weighted average cost of capital

S B
RWACC = × RS + × RB
S+B S+B

Recall the example of levered and unlevered firms

$0 $20, 000
Unlevered firm: RWACC = × 8% + × 10% = 10%
$20, 000 $20, 000

$8, 000 $12, 000

Unlevered firm: RWACC = × 8% + × 11.3% = 10%
$20, 000 $20, 000

M&M proposition I implies that WACC is constant for a given firm re-
gardless of the capital structure (in a world with no taxes).

18
Implication of M&M I (No Taxes): WACC

Denote the cost of capital for an all-equity firm as R0 .

19
Implication of M&M I (No Taxes): WACC

Denote the cost of capital for an all-equity firm as R0 .

Therefore, WACC always equal to R0 in a world with no taxes.

19
Implication of M&M I (No Taxes): WACC

Denote the cost of capital for an all-equity firm as R0 .

Therefore, WACC always equal to R0 in a world with no taxes.

S B
RWACC = × RS + × RB = R0
S+B S+B

19
Implication of M&M I (No Taxes): WACC

Denote the cost of capital for an all-equity firm as R0 .

Therefore, WACC always equal to R0 in a world with no taxes.

S B
RWACC = × RS + × RB = R0
S+B S+B

That is,
S B
R0 = × RS + × RB
S+B S+B

19
M&M Proposition II (No Taxes)

Derived from RWACC = R0 , M&M proposition II (no taxes) states:

B
RS = R0 + × (R0 − RB )
S

RS : the return on (levered) equity (cost of equity).

RB : the interest rate (cost of debt).
R0 : the return on unlevered equity (cost of all-equity capital).
B: the value of debt.
S: the value of levered equity.

20
M&M Proposition II (No Taxes): Derivation

Setting RWACC = R0 yields

S B
× RS + × RB = R0
S+B S+B

21
M&M Proposition II (No Taxes): Derivation

Setting RWACC = R0 yields

S B
× RS + × RB = R0
S+B S+B

B+S
Multiply both sides by S and rearrange

B+S B
RS = × R0 − × RB
S S

21
M&M Proposition II (No Taxes): Derivation

Setting RWACC = R0 yields

S B
× RS + × RB = R0
S+B S+B

B+S
Multiply both sides by S and rearrange

B+S B
RS = × R0 − × RB
S S
B B
RS = R0 + × R0 − × RB
S S
Thus,
B
RS = R0 + × (R0 − RB )
S

21
M&M Proposition II (No Taxes): Interpretation

B
RS = R0 + × (R0 − RB )
S
Normally, R0 > RB .

22
M&M Proposition II (No Taxes): Interpretation

B
RS = R0 + × (R0 − RB )
S
Normally, R0 > RB .

The cost of equity rises with increases in the debt-to-equity ratio.

22
M&M Proposition II (No Taxes): Interpretation

B
RS = R0 + × (R0 − RB )
S
Normally, R0 > RB .

The cost of equity rises with increases in the debt-to-equity ratio.

M&M proposition II (no taxes) implies that levered equity has a greater
return. (Why?)

22
M&M Proposition II (No Taxes): Interpretation

B
RS = R0 + × (R0 − RB )
S
Normally, R0 > RB .

The cost of equity rises with increases in the debt-to-equity ratio.

M&M proposition II (no taxes) implies that levered equity has a greater
return. (Why?)

• Compensation for the higher risk of levered equity

22
Return and Risk to Levered Firm’s Shareholders

Leverage increases return and risk to shareholders

23
Return and Risk to Levered Firm’s Shareholders

Leverage increases return and risk to shareholders

• The EPS and ROE vary in a greater range for the levered firm.

23
Return and Risk to Levered Firm’s Shareholders

Leverage increases return and risk to shareholders

• The EPS and ROE vary in a greater range for the levered firm.
• The expected EPS and ROE are higher for the levered firm.

23
Cost of Capital vs. Debt-to-Equity Ratio

24
Cost of Capital vs. Debt-to-Equity Ratio

The firm’s weighted average cost of capital, RWACC , is invariant to the

firm’s debt-to-equity ratio.

24
Cost of Capital vs. Debt-to-Equity Ratio

The firm’s weighted average cost of capital, RWACC , is invariant to the

firm’s debt-to-equity ratio.
The cost of equity capital, RS is positively related to the firm’s debt-
to-equity ratio.

24
M&M Proposition I and II (No Taxes): Example

An all-equity firm is considering an expansion with a new plant.

The cost of capital for this unlevered firm is 10%.

The borrowing rate in the market is 6%.

25
M&M Proposition I and II (No Taxes): Example

What is the current value of this firm?

26
M&M Proposition I and II (No Taxes): Example

What is the current value of this firm?

$10 million
Existing asset = = $100 million
.10

26
M&M Proposition I and II (No Taxes): Example

What is the current value of this firm?

$10 million
Existing asset = = $100 million
.10

26
M&M Proposition I and II (No Taxes): Example

What is the current value of this firm?

$10 million
Existing asset = = $100 million
.10

Stock price per share is

26
M&M Proposition I and II (No Taxes): Example

What is the current value of this firm?

$10 million
Existing asset = = $100 million
.10

Stock price per share is

$100 million / 10 million = $10

26
M&M Proposition I and II (No Taxes): Example

Since the new plant for expansion bears a similar level of risk as the
existing firm, the project can be discounted at the same rate as the
firm as a whole.

27
M&M Proposition I and II (No Taxes): Example

Since the new plant for expansion bears a similar level of risk as the
existing firm, the project can be discounted at the same rate as the
firm as a whole.
Thus, the NPV of the new plant is

27
M&M Proposition I and II (No Taxes): Example

Since the new plant for expansion bears a similar level of risk as the
existing firm, the project can be discounted at the same rate as the
firm as a whole.
Thus, the NPV of the new plant is

$1 million
−$4 million + = $6 million
.10

27
M&M Proposition I and II (No Taxes): Example

Since the new plant for expansion bears a similar level of risk as the
existing firm, the project can be discounted at the same rate as the
firm as a whole.
Thus, the NPV of the new plant is

$1 million
−$4 million + = $6 million
.10

To raise capital for the expansion, the firm could issue $4 million of
either equity or debt.

27
M&M Proposition I and II (No Taxes): Example

Stock Financing

28
M&M Proposition I and II (No Taxes): Example

Stock Financing

Upon the announcement of the expansion with stock financing in a

near future, the firm value increases to reflect the positive NPV gen-
erated by the new plant.

28
M&M Proposition I and II (No Taxes): Example

Stock Financing

Upon the announcement of the expansion with stock financing in a

near future, the firm value increases to reflect the positive NPV gen-
erated by the new plant.

28
M&M Proposition I and II (No Taxes): Example

Stock Financing

Upon the announcement of the expansion with stock financing in a

near future, the firm value increases to reflect the positive NPV gen-
erated by the new plant.

Stock price per share is:

28
M&M Proposition I and II (No Taxes): Example

Stock Financing

Upon the announcement of the expansion with stock financing in a

near future, the firm value increases to reflect the positive NPV gen-
erated by the new plant.

Stock price per share is: $106 million / 10 million = $10.60

28
M&M Proposition I and II (No Taxes): Example

Soon, the firm issues $4 million of equities. And the number of shares
issued is:

29
M&M Proposition I and II (No Taxes): Example

Soon, the firm issues $4 million of equities. And the number of shares
issued is: $4 million / $10.6 = 377, 359

29
M&M Proposition I and II (No Taxes): Example

Soon, the firm issues $4 million of equities. And the number of shares
issued is: $4 million / $10.6 = 377, 359

The stock price per share is:

29
M&M Proposition I and II (No Taxes): Example

Soon, the firm issues $4 million of equities. And the number of shares
issued is: $4 million / $10.6 = 377, 359

The stock price per share is: $10.60

29
M&M Proposition I and II (No Taxes): Example

Shortly, the $4 million is used to build the new plant.

The present value of the new plant is $10 million ($1 million / .10).

30
M&M Proposition I and II (No Taxes): Example

Shortly, the $4 million is used to build the new plant.

The present value of the new plant is $10 million ($1 million / .10).

30
M&M Proposition I and II (No Taxes): Example

Shortly, the $4 million is used to build the new plant.

The present value of the new plant is $10 million ($1 million / .10).

The stock price per share is:

30
M&M Proposition I and II (No Taxes): Example

Shortly, the $4 million is used to build the new plant.

The present value of the new plant is $10 million ($1 million / .10).

The stock price per share is: $10.60

30
M&M Proposition I and II (No Taxes): Example

What is the return to equityholders?

31
M&M Proposition I and II (No Taxes): Example

What is the return to equityholders?

Every year, the cash flow to equityholders is

$10 million + $1 million = $11 million

31
M&M Proposition I and II (No Taxes): Example

What is the return to equityholders?

Every year, the cash flow to equityholders is

$10 million + $1 million = $11 million

Thus, the return to equityholders is

$11 million
RS = = .10 = 10%
$110 million

31
M&M Proposition I and II (No Taxes): Example

What is the return to equityholders?

Every year, the cash flow to equityholders is

$10 million + $1 million = $11 million

Thus, the return to equityholders is

$11 million
RS = = .10 = 10%
$110 million

For this all-equity firm, R0 = RS = 10%

31
M&M Proposition I and II (No Taxes): Example

Debt financing

32
M&M Proposition I and II (No Taxes): Example

Debt financing

Upon the announcement of expansion by debt financing in a near

future, the firm value increases to reflect the positive NPV generated
by the new plant.

32
M&M Proposition I and II (No Taxes): Example

Debt financing

Upon the announcement of expansion by debt financing in a near

future, the firm value increases to reflect the positive NPV generated
by the new plant.

Stock price per share is:

32
M&M Proposition I and II (No Taxes): Example

Debt financing

Upon the announcement of expansion by debt financing in a near

future, the firm value increases to reflect the positive NPV generated
by the new plant.

Stock price per share is: $106 million / 10 million = $10.60

32
M&M Proposition I and II (No Taxes): Example

At some point, the firm issues debt of $4 million at 6%.

33
M&M Proposition I and II (No Taxes): Example

At some point, the firm issues debt of $4 million at 6%.

• The firm receives $4 million proceeds from debt issuance.
• The annual interest payments to debt holders are $240,000.

33
M&M Proposition I and II (No Taxes): Example

At some point, the firm issues debt of $4 million at 6%.

• The firm receives $4 million proceeds from debt issuance.
• The annual interest payments to debt holders are $240,000.

33
M&M Proposition I and II (No Taxes): Example

At some point, the firm issues debt of $4 million at 6%.

• The firm receives $4 million proceeds from debt issuance.
• The annual interest payments to debt holders are $240,000.

The stock price per share is:

33
M&M Proposition I and II (No Taxes): Example

At some point, the firm issues debt of $4 million at 6%.

• The firm receives $4 million proceeds from debt issuance.
• The annual interest payments to debt holders are $240,000.

The stock price per share is: $10.60

33
M&M Proposition I and II (No Taxes): Example

Finally, the contractor receives the $4 million and builds the new plant.
The PV of cash flows from the plant is $10 million.

34
M&M Proposition I and II (No Taxes): Example

Finally, the contractor receives the $4 million and builds the new plant.
The PV of cash flows from the plant is $10 million.

34
M&M Proposition I and II (No Taxes): Example

Finally, the contractor receives the $4 million and builds the new plant.
The PV of cash flows from the plant is $10 million.

The stock price per share is:

34
M&M Proposition I and II (No Taxes): Example

Finally, the contractor receives the $4 million and builds the new plant.
The PV of cash flows from the plant is $10 million.

The stock price per share is: $10.60

34
M&M Proposition I and II (No Taxes): Example

What is the return to equityholders?

35
M&M Proposition I and II (No Taxes): Example

What is the return to equityholders?

Every year, the cash flow to equityholders is

$10, 000, 000 + 1, 000, 000 − 240, 000 = $10, 760, 000

35
M&M Proposition I and II (No Taxes): Example

What is the return to equityholders?

Every year, the cash flow to equityholders is

$10, 000, 000 + 1, 000, 000 − 240, 000 = $10, 760, 000

Thus, return to equityholder is

$10, 760, 000

RS = = .1015 = 10.15%
$106, 000, 000

35
M&M Proposition I and II (No Taxes): Example

The return for levered equityholders (10.5%) is higher than the return
for unlevered equityholders (10%).

36
M&M Proposition I and II (No Taxes): Example

The return for levered equityholders (10.5%) is higher than the return
for unlevered equityholders (10%).

In fact, M&M II (no taxes) predits

B
RS = R0 + × (R0 − RB )
S
$4, 000, 000
RS = .10 + × (.10 − .06) = .1015 = 10.15%
$106, 000, 000

36
M&M Proposition I and II (No Taxes): Example

Regardless of whether equity financing or debt financing is used,

• Firm value is always $110 million.

• Stock price is always $10.60 per share.

37
M&M Proposition I and II (No Taxes): Example

Regardless of whether equity financing or debt financing is used,

• Firm value is always $110 million.

• Stock price is always $10.60 per share.

→ Consistent with M&M Proposition I (No Taxes)

37
M&M Proposition I and II (No Taxes): Example

Regardless of whether equity financing or debt financing is used,

• Firm value is always $110 million.

• Stock price is always $10.60 per share.

→ Consistent with M&M Proposition I (No Taxes)

Relative to equity financing, the use of debt financing increases the

return to equityholders from 10% to 10.15%.

37
M&M Proposition I and II (No Taxes): Example

Regardless of whether equity financing or debt financing is used,

• Firm value is always $110 million.

• Stock price is always $10.60 per share.

→ Consistent with M&M Proposition I (No Taxes)

Relative to equity financing, the use of debt financing increases the

return to equityholders from 10% to 10.15%.
→ Consistent with M&M Proposition II (No Taxes)

37
M&M Propositions Without Taxes: Summary

Assumptions
• No taxes
• No transaction costs
• Individual and firms can borrow/lend at the same rate
Results
• Proposition I: VL = VU
B
• Proposition II: RS = R0 + S × (R0 − RB )
Intuition
• Proposition I: Through homemade leverage, shareholders can
either duplicate or undo the effects of corporate leverage with
homemade leverage/unleverage.
• Proposition II: The cost of equity rises with leverage because the
risk to equity rises with leverage.
38
Taxes and M&M with Corp Taxes
Tax Shield

Interest payment to bondholders is tax deductible.

Interest = Interest rate × Amount borrowed = RB × B

39
Tax Shield

Interest payment to bondholders is tax deductible.

Interest = Interest rate × Amount borrowed = RB × B

Tax shield from debt (reduction in corporate taxes):

39
Tax Shield

Interest payment to bondholders is tax deductible.

Interest = Interest rate × Amount borrowed = RB × B

Tax shield from debt (reduction in corporate taxes):
TC × RB × B

39
Tax Shield

Interest payment to bondholders is tax deductible.

Interest = Interest rate × Amount borrowed = RB × B

Tax shield from debt (reduction in corporate taxes):
TC × RB × B
Leverage increases the total CF to stakeholders by the tax shield.
39
Present Value of the Tax Shield

Assume the cash flows in corporate tax payments have the same risk
as the interest on the debt.
Assume the cash flows are perpetual.

40
Present Value of the Tax Shield

Assume the cash flows in corporate tax payments have the same risk
as the interest on the debt.
Assume the cash flows are perpetual.

The present value of the tax shield is:

40
Present Value of the Tax Shield

Assume the cash flows in corporate tax payments have the same risk
as the interest on the debt.
Assume the cash flows are perpetual.

The present value of the tax shield is:

TC RB B
= TC B
RB

40
Value of Unlevered Firm with Taxes

The annual aftertax cash flow is:

41
Value of Unlevered Firm with Taxes

The annual aftertax cash flow is:

EBIT × (1 − TC )

41
Value of Unlevered Firm with Taxes

The annual aftertax cash flow is:

EBIT × (1 − TC )

The value of the firm (the PV of the CF) is:

41
Value of Unlevered Firm with Taxes

The annual aftertax cash flow is:

EBIT × (1 − TC )

The value of the firm (the PV of the CF) is:

EBIT × (1 − TC )
VU =
R0

VU = PV of an unlevered firm
EBIT × (1 − TC ) = firm CF after corporate taxes
TC = corporate tax rate
R0 = cost of capital to an all-equity firm

41
Value of Levered Firm with Taxes

The total cash flow to all stakeholders is:

42
Value of Levered Firm with Taxes

The total cash flow to all stakeholders is:

(EBIT − RB × B) × (1 − TC ) + RB × B

42
Value of Levered Firm with Taxes

The total cash flow to all stakeholders is:

(EBIT − RB × B) × (1 − TC ) + RB × B

Rearrange the items yields:

EBIT × (1 − TC ) − (1 − TC ) × RB × B + RB × B
[ ] [ ]
EBIT × (1 − TC ) + TC × RB × B

42
Value of Levered Firm with Taxes

The total cash flow to all stakeholders is:

(EBIT − RB × B) × (1 − TC ) + RB × B

Rearrange the items yields:

EBIT × (1 − TC ) − (1 − TC ) × RB × B + RB × B
[ ] [ ]
EBIT × (1 − TC ) + TC × RB × B

The present value of this stream of cash flows is:

42
Value of Levered Firm with Taxes

The total cash flow to all stakeholders is:

(EBIT − RB × B) × (1 − TC ) + RB × B

Rearrange the items yields:

EBIT × (1 − TC ) − (1 − TC ) × RB × B + RB × B
[ ] [ ]
EBIT × (1 − TC ) + TC × RB × B

The present value of this stream of cash flows is:

EBIT × (1 − TC ) TC RB B
VL = + = VU + TC B
R0 RB

42
M&M Proposition I (With Taxes)

M&M Proposition I under corporate taxes:

VL = VU + TC B

43
M&M Proposition I (With Taxes)

M&M Proposition I under corporate taxes:

VL = VU + TC B

Leverage increases the firm value by the tax shield, which is TC B for
perpetual debt.

43
M&M Proposition I (With Taxes)

M&M Proposition I under corporate taxes:

VL = VU + TC B

Leverage increases the firm value by the tax shield, which is TC B for
perpetual debt.

In the presence of corporate taxes, the firm’s value is positively related

to its debt.

43
M&M Proposition I (With Taxes): Example

The corporate rax rate is 21%. An all-equity firm expects to generate

aftertax earnings of $100 in perpetuity. All aftertax earnings are paid
out as dividends.

44
M&M Proposition I (With Taxes): Example

The corporate rax rate is 21%. An all-equity firm expects to generate

aftertax earnings of $100 in perpetuity. All aftertax earnings are paid
out as dividends.
The firm is considering a capital restructuring to allow $200 of debt
with the cost of debt to be 10%. Unlevered firms in the same industry
have a cost of capital of 20%.

44
M&M Proposition I (With Taxes): Example

The corporate rax rate is 21%. An all-equity firm expects to generate

aftertax earnings of $100 in perpetuity. All aftertax earnings are paid
out as dividends.
The firm is considering a capital restructuring to allow $200 of debt
with the cost of debt to be 10%. Unlevered firms in the same industry
have a cost of capital of 20%.
What is the value of this firm after capital restructuring?

44
M&M Proposition I (With Taxes): Example

The corporate rax rate is 21%. An all-equity firm expects to generate

aftertax earnings of $100 in perpetuity. All aftertax earnings are paid
out as dividends.
The firm is considering a capital restructuring to allow $200 of debt
with the cost of debt to be 10%. Unlevered firms in the same industry
have a cost of capital of 20%.
What is the value of this firm after capital restructuring?

EBIT × (1 − TC )
VL = + TC B
R0

44
M&M Proposition I (With Taxes): Example

The corporate rax rate is 21%. An all-equity firm expects to generate

aftertax earnings of $100 in perpetuity. All aftertax earnings are paid
out as dividends.
The firm is considering a capital restructuring to allow $200 of debt
with the cost of debt to be 10%. Unlevered firms in the same industry
have a cost of capital of 20%.
What is the value of this firm after capital restructuring?

EBIT × (1 − TC )
VL = + TC B
R0

$100
VL = + .21 × $200 = $542
.20

44
M&M Proposition I (With Taxes): Example

45
M&M Proposition I (With Taxes): Example

Debt reduces the firm’s tax burden.

As a result, the value of the firm is positively related to debt.

45
M&M Proposition II (With Taxes)

M&M proposition I with taxes implies that:

46
M&M Proposition II (With Taxes)

M&M proposition I with taxes implies that:

Hence, the expected CFs generated by the value should equal to the
expected CFs distributed to stakeholders.

VU × R0 + TC × B × RB = S × RS + B × RB

46
M&M Proposition II (With Taxes)

M&M proposition I with taxes implies that:

Hence, the expected CFs generated by the value should equal to the
expected CFs distributed to stakeholders.

VU × R0 + TC × B × RB = S × RS + B × RB

Derived from the results above, M&M proposition II with taxes states:
B
RS = R0 + × (1 − TC ) × (R0 − RB )
S

46
M&M Proposition II (With Taxes): Derivation

Start with M&M Proposition I with taxes: VL = VU + TC B

47
M&M Proposition II (With Taxes): Derivation

Start with M&M Proposition I with taxes: VL = VU + TC B

Since VL = S + B, S + B = VU + TC B. Thus,

VU = S + (1 − TC )B

47
M&M Proposition II (With Taxes): Derivation

Start with M&M Proposition I with taxes: VL = VU + TC B

Since VL = S + B, S + B = VU + TC B. Thus,

VU = S + (1 − TC )B

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

VU × R0 + TC × B × RB = S × RS + B × RB
[ ]
S + (1 − TC )B × R0 + TC × B × RB = S × RS + B × RB

47
M&M Proposition II (With Taxes): Derivation

Start with M&M Proposition I with taxes: VL = VU + TC B

Since VL = S + B, S + B = VU + TC B. Thus,

VU = S + (1 − TC )B

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

VU × R0 + TC × B × RB = S × RS + B × RB
[ ]
S + (1 − TC )B × R0 + TC × B × RB = S × RS + B × RB

Divide both sides by S

[ B ] B B
1 + (1 − TC ) × R0 + × TC × RB = RS + × RB
S S S

47
M&M Proposition II (With Taxes): Derivation

Start with M&M Proposition I with taxes: VL = VU + TC B

Since VL = S + B, S + B = VU + TC B. Thus,

VU = S + (1 − TC )B

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

VU × R0 + TC × B × RB = S × RS + B × RB
[ ]
S + (1 − TC )B × R0 + TC × B × RB = S × RS + B × RB

Divide both sides by S

[ B ] B B
1 + (1 − TC ) × R0 + × TC × RB = RS + × RB
S S S
B
Which quickly reduces to: RS = R0 + S × (1 − TC ) × (R0 − RB )

47
M&M Proposition II (With Taxes): Interpretation

B
RS = R0 + × (1 − TC ) × (R0 − RB )
S

Equity asset (even equity of unlevered firm) is risky, and therefore

should have an expected return higher than that on the less-risky
debt: R0 > RB .

48
M&M Proposition II (With Taxes): Interpretation

B
RS = R0 + × (1 − TC ) × (R0 − RB )
S

Equity asset (even equity of unlevered firm) is risky, and therefore

should have an expected return higher than that on the less-risky
debt: R0 > RB .

The cost of equity, RS , increases with leverage.

48
M&M Proposition II (With Taxes): Interpretation

B
RS = R0 + × (1 − TC ) × (R0 − RB )
S

Equity asset (even equity of unlevered firm) is risky, and therefore

should have an expected return higher than that on the less-risky
debt: R0 > RB .

The cost of equity, RS , increases with leverage.

Financial leverage adds risk to the firm’s equity. As a compensation,
the cost of equity rises with the financial leverage.

48
The Effect of Financial Leverage: Cost of Equity

Leverage increases the risk and return to stockholders (MM Proposi-

tion II - No taxes).
Some of the increase in equity risk and return is offset by the interest
tax shield (MM Proposition II - With taxes).

49
The Effect of Financial Leverage: WACC

S B
RWACC = × RS + × RB × (1 − TC )
V V

50
The Effect of Financial Leverage: WACC

S B
RWACC = × RS + × RB × (1 − TC )
V V

In the no-tax case, WACC is unaffected by leverage.

However, because debt is tax-advantaged relative to equity, WACC de-
clines with leverage in a world with corporate taxes.
50
Stock Prices and Leverage Under
Corporate Taxes
Financial Leverage and Stock Price (With Taxes)

So far, we have shown that the capital structure that maximizes firm
value is also the one that most benefits the interest of the stockhold-
ers.

51
Financial Leverage and Stock Price (With Taxes)

So far, we have shown that the capital structure that maximizes firm
value is also the one that most benefits the interest of the stockhold-
ers.

If managers hope to maximize stockholder’s interest, why don’t try to

maximize the stock price?

51
Financial Leverage and Stock Price (With Taxes)

So far, we have shown that the capital structure that maximizes firm
value is also the one that most benefits the interest of the stockhold-
ers.

If managers hope to maximize stockholder’s interest, why don’t try to

maximize the stock price?

• In fact, an increase in the firm value from debt financing would

lead to a rise in the stock price.

51
Financial Leverage and Stock Price (With Taxes): Example

An all equity firm has a firm value of $500.

There are 100 shares outstanding, each share is worth $5.
The corporate tax rate is 21%.

52
Financial Leverage and Stock Price (With Taxes): Example

The firm announces it will issue $200 debt to buy back $200 of stock.

53
Financial Leverage and Stock Price (With Taxes): Example

The firm announces it will issue $200 debt to buy back $200 of stock.

The value of the firm rises, reflecting the tax shield of debt.

53
Financial Leverage and Stock Price (With Taxes): Example

The firm announces it will issue $200 debt to buy back $200 of stock.

The value of the firm rises, reflecting the tax shield of debt.

Stock price is now

53
Financial Leverage and Stock Price (With Taxes): Example

The firm announces it will issue $200 debt to buy back $200 of stock.

The value of the firm rises, reflecting the tax shield of debt.

Stock price is now $5.42 (efficient market).

53
Financial Leverage and Stock Price (With Taxes): Example

The firm announces it will issue $200 debt to buy back $200 of stock.

The value of the firm rises, reflecting the tax shield of debt.

Stock price is now $5.42 (efficient market).

Shareholders are benefiting from the improved financial policy.

53
Financial Leverage and Stock Price (With Taxes): Example

Exchange of debt for equity: debt of $200 is issued and the proceeds
are used to buy back shares

54
Financial Leverage and Stock Price (With Taxes): Example

Exchange of debt for equity: debt of $200 is issued and the proceeds
are used to buy back shares

What is the repurchase price? How many shared are repurchased?

54
Financial Leverage and Stock Price (With Taxes): Example

Exchange of debt for equity: debt of $200 is issued and the proceeds
are used to buy back shares

What is the repurchase price? How many shared are repurchased?

• $200 / $5.42 = 36.90 shares

54
Financial Leverage and Stock Price (With Taxes): Example

Exchange of debt for equity: debt of $200 is issued and the proceeds
are used to buy back shares

What is the repurchase price? How many shared are repurchased?

• $200 / $5.42 = 36.90 shares

54
Financial Leverage and Stock Price (With Taxes): Example

Exchange of debt for equity: debt of $200 is issued and the proceeds
are used to buy back shares

What is the repurchase price? How many shared are repurchased?

• $200 / $5.42 = 36.90 shares

Stock price does not change on the exchange date: $342 / 63.1 = $5.42
54
M&M Propositions with Taxes: Summary

Assumptions
• Firms are taxed at the rate TC on earnings after interest.
• There are no transaction or bankcruptcy costs.
• Individual and firms can borrow/lend at the same rate.
Results
• Proposition I: VL = VU + TC B
• Proposition II: RS = R0 + BS (1 − TC )(R0 − RB )
Intuition
• Propositions I: Because firms can deduct interest but not
dividends, financial leverage lowers firms’ corporate tax
payments.
• Proposition II: The cost of equity rises with leverage because the
risk to equity increases with leverage.
55
Capital Structure: Basics

End of Main Content

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