Because learning changes everything.
Corporate Finance Thirteenth Edition
Stephen A. Ross / Randolph W. Westerfield / Jeffrey F. Jaffe /
Bradford D. Jordan
Chapter 16
Capital Structure: Basic Concepts
© McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.
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.
© McGraw Hill, LLC 2
Chapter Outline
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
© McGraw Hill, LLC 3
16.1 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
• 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.
© McGraw Hill, LLC 4
16.2 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
shareholders’ value?
As it turns out, changes in capital structure primarily benefit
the stockholders if the value of the firm increases.
© McGraw Hill, LLC 5
16.3 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.)
© McGraw Hill, LLC 6
EPS and ROE under each capital structure
Current capital structure
Proposed capital structure
© McGraw Hill, LLC 7
Financial Leverage and EPS
Access the text alternative for slide images
© McGraw Hill, LLC 8
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.
© McGraw Hill, LLC 9
The choice between debt and equity
Payoff and Cost to Shareholders under the Proposed
Structure and under the Current Structure with Homemade
Leverage
© McGraw Hill, LLC 10
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
© McGraw Hill, LLC 11
16.4 MM Proposition II (No Taxes)
Proposition II
• Leverage increases the risk and return to stockholders.
B
Rs R0 R0 RB
S
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.
S is the value of levered equity.
© McGraw Hill, LLC 12
MM Proposition II (No Taxes)
The derivation is straightforward:
B S
WACC R0 RB RS
BS BS
B S BS
RB RS 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
RB RS R0 R0 RS R0 R0 RB
S S S
© McGraw Hill, LLC 13
MM Proposition II (No Taxes)
As the firm raises the debt-equity ratio, each dollar of equity is
levered with additional debt. This raises the risk of equity and
therefore the required return Rs on the equity.
Access the text alternative for slide images
© McGraw Hill, LLC 14
16.5 MM 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
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
B is capital).
the value of debt.
S is the value of levered equity.
© McGraw Hill, LLC 15
MM Proposition I (With Taxes)
The value of an unlevered firm
The tax shield
The value of a levered firm
© McGraw Hill, LLC 16
MM 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 BRB VU R0 TC BRB
SRS BRB S B 1 TC R0 TC RB B
Divide both sides by S
B B B
RB 1 1 TC R0 TC RB
RS
S S S
B
Which quickly reduces to: R S R0 1 TC R0 RB
S
© McGraw Hill, LLC 17
The Effect of Financial Leverage
Financial leverage adds risk to the firm’s equity.
As compensation, the cost of equity rises with the firm’s risk.
Access the text alternative for slide images
© McGraw Hill, LLC 18
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
S
© McGraw Hill, LLC 19
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.
RS R0 B / S 1 TC R0 RB
© McGraw Hill, LLC 20
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?
© McGraw Hill, LLC 21
End of Main Content
Because learning changes everything. ®
[Link]
© McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.
