Principles of Finance

Topic 9: Capital Structure

Lecturer: Yue (Lucy) Liu

Slides are based on Ch 14, 15 and16 in Berk and DeMarzo (3rd edition).
 Outline

 Leverage and value of a firm

 Modiglianni and Miller I & 2 in perfect capital markets

 Modiglianni and Miller I & 2 with tax

 Two theories of capital structure

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 Outline

 Leverage and value of a firm

 Modiglianni and Miller I & 2 in perfect capital markets

 Modiglianni and Miller I & 2 with tax

 Two theories of capital structure

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 Leverage and firm value

 Capital Structure

The relative proportions of debt, equity, and other securities that a firm has
outstanding.

 When corporations raise funds externally, they must choose which type of
security to issue.

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 Leverage and firm value

Example 1:
An entrepreneur is considering an investment opportunity. For an initial investment of
$800 this year, the project will generate cash flows of either $1400 or $900 next year,
depending on whether the economy is strong or weak, respectively. Both scenarios are
equally likely. Cost of capital for this project is 15%.

Expected CF in 1 year = ½($1400) + ½($900) = $1150

$1150
NPV   $800    $800  $1000  $200
1.15

Financed by equity only, how much would investors be willing to pay for the project?

$1150
Price of a security = PV (equity cash flows)   $1000
1.15
The entrepreneur can raise $1000 by selling equity. After making the initial investment
of $800, keep the remaining $200 as a profit.
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 Leverage and firm value (Cont’d)

 Unlevered Equity: Equity in a firm with no debt

 Returns for Unlevered Equity

 Expected return on the unlevered equity = ½ (40%) + ½(–10%) = 15%.

 Because the cost of capital of the project is 15%, shareholders are

earning an appropriate return for the risk they are taking.

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 Leverage and firm value (Cont’d)

Financed by debt and equity

Suppose he decides to borrow $500 initially, in addition to selling equity. The

debt is risk free and he can borrow at risk free rate of 5% (because the project’s
CF will always be enough to repay the debt). He will owe the debt holders: $500
× 1.05 = $525 in one year.

 Levered Equity: Equity in a firm that also has debt outstanding

1000-500=$500 1400-525=$875 900-525=$375

 Leverage and firm value (Cont’d)

 In perfect capital markets, if 100% equity financed:

The equity holders will require a 15% expected return.

 If financed 50% with debt and 50% with equity:

Debt holders will receive a return of 5%; levered equity holders will require an expected return of 25%
because of their increased risk. Leverage increases the risk of the equity!

What is the average cost of capital for the firm?

𝐷 𝐸 $500 $500
𝑟𝑊𝐴𝐶𝐶 𝑟 𝑟 5% + 25% = 𝟏𝟓%
= 𝐷+𝐸 𝐷 + 𝐷+𝐸 𝐸 = $500 + $500 $500 + $500
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 Leverage and firm value (Cont’d)

 Leverage increases the risk of equity even when there is no risk that the
firm will default. (Leverage could increase the sensitivity of cash flows.)

 While debt may be cheaper, its use raises the cost of capital for equity.

 Considering both sources of capital together, the average cost of capital

with leverage is the same as for the unlevered firm.

 The Law of One Price implies that leverage will not affect the total value
of the firm. It merely changes the allocation of cash flows between debt
and equity, without altering the total cash flows of the firm.

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 Outline

 Leverage and value of a firm

 Modiglianni and Miller I & 2 in perfect capital markets

 Modiglianni and Miller I & 2 with tax

 Two theories of capital structure

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 Modigliani-Miller I: Leverage and Firm Value

 Modigliani and Miller (MM) showed that this result holds more generally
under a set of conditions referred to as perfect capital markets:

– Investors and firms can trade the same set of securities at competitive
market prices equal to the present value of their future cash flows.
– There are no taxes, transaction costs, or issuance costs associated
with security trading.
– A firm’s financing decisions do not change the cash flows generated by
its investments, nor do they reveal new information about them.

 MM Proposition I:

In a perfect capital market, the total value of a firm is equal to the market value of the total

cash flows generated by its assets and is not affected by its choice of capital structure.

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 Modigliani-Miller I (Cont’d)

Capital Structure and Firm Value under M&M Proposition 1

With perfect capital markets, the capital structure doesn’t change

the size of the pie; it only changes how the pie is sliced.
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 Modigliani-Miller I (Cont’d)

How about if investors would prefer an alternative capital structure to the

one the firm has chosen…

 MM demonstrated that if investors would prefer an alternative capital

structure to the one the firm has chosen, investors can borrow or lend on

their own and achieve the same result. • Prefer levered equity, buy stock on margin (borrowing).

• Prefer unlevered equity, buy debt (lending).

 Homemade Leverage

When investors use leverage in their own portfolios to adjust the leverage
choice made by the firm.

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 Modigliani-Miller II:
Leverage, Risk, and the Cost of Capital

 The return on unlevered equity (RU) is related to the returns of levered equity (RE)
and debt (RD): E D
RE  RD  RU
E  D E  D

𝐷
Solving for RE: 𝑅𝐸 = 𝑅𝑈 + (𝑅𝑈 − 𝑅𝐷 )
𝐸

Risk without Additional risk

leverage due to leverage

 MM Proposition II:

The cost of capital of levered equity is equal to the cost of capital of unlevered
equity plus a premium that is proportional to the market value debt-equity ratio.
(Relationship between leverage and the equity cost of capital)

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 Modigliani-Miller II (Cont’d)

Example 2:

If firm XYZ is all-equity financed, the expected return on unlevered equity is 15%. If
the firm is financed with $500 of debt and $500 of equity, the expected return of the
debt is 5%. What is the expected return on equity for the levered firm?

Solution:

According to MM Proposition II, the expected return on equity for the levered firm:

500
rE  15%  (15%  5%)  25%
500

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 Modigliani-Miller II (Cont’d)

WACC and leverage with perfect capital markets

 If a firm is unlevered, all of the free cash flows generated by its assets are paid out
to its equity holders.
rU  rA

 If a firm is levered, rA is equal to the firm’s weighted average cost of capital.

E D
rwacc  rA  rE  rD
ED ED

 With perfect capital markets, a firm’s WACC is independent of its capital structure
and is equal to its equity cost of capital if it is unlevered, which matches the cost of
capital of its assets.
rwacc  rU  rA

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WACC and Leverage with Perfect Capital Markets

As the firm borrows at the low cost of capital for debt, its equity cost of capital
rises. The net effect is that the firm’s WACC is unchanged.

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 Outline

 Leverage and value of a firm

 Modiglianni and Miller I & 2 in perfect capital markets

 Modiglianni and Miller I & 2 with tax

 Two theories of capital structure

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 MM Proposition I & II with Taxes

 MM I with taxes

The total value of the levered firm exceeds the value of the firm without
leverage due to the present value of the tax savings from debt.

V L  V U  PV (Interest Tax Shield)

The reduction in taxes paid due to the tax deductibility of interest.

Interest Tax Shield  Corporate Tax Rate  Interest Payments

 MM II with taxes

D
rE  rU  (rU  rD )  (1   C )
E

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 MM Proposition I & II with Taxes

Capital Structure and Firm Value with Taxes

Interest tax shield Interest tax shield

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 Outline

 Leverage and value of a firm

 Modiglianni and Miller I & 2 in perfect capital markets

 Modiglianni and Miller I & 2 with tax

 Two theories of capital structure

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 The Tradeoff Theory

 Tradeoff Theory:

The firm picks its capital structure by trading off the benefits of the tax
shield from debt against the costs of financial distress.

 According to the tradeoff theory, the total value of a levered firm equals the
value of the firm without leverage plus the present value of the tax savings
from debt, less the present value of financial distress costs.

V L  V U  PV (Interest Tax Shield)  PV (Financial Distress Costs)

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 Pecking order hypothesis

 Pecking Order Hypothesis

Managers will prefer to fund investments by first using retained earnings, then debt and
equity only as a last resort.

Internal financing:
Retained earnings

External financing:
Debt

External financing:
Equity

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 Pecking order hypothesis

 Adverse Selection & Lemons Principle

Suppose a used-car dealer is willing to sell a car for a

low price (e.g. £4,000).

 Potential buyers might be skeptical – it is probably a “lemon”.

 Owners of high-quality cars are reluctant to sell because they know buyers will think they
are selling a lemon. Only the owners of low-quality cars are willing to sell.

 Consequently, the quality and the prices in the used-car market are both low.

(Adverse Selection)

 Lemons principle:

When a seller has private information about the value of a good, buyers will discount the
price they are willing to pay due to adverse selection.

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 Pecking order hypothesis

 Managers who know their prospects are good (i.e. who perceive the firm’s
equity is underpriced) will not sell new equity. They will have a preference to
fund investment using retained earnings, or debt, rather than equity.

 Only those managers who know their firms have poor prospects are willing
to sell new equity.

 Some empirical studies show that the stock price declines on the
announcement of an equity issue.

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 Quiz

 How does the risk and cost of capital of levered equity compare to that of
unlevered equity? Which is the superior capital structure choice in a perfect
capital market?

 With perfect capital markets, as a firm increases its leverage, how does its
debt cost of capital change? Its equity cost of capital? Its weighted average
cost of capital?

 What are MM I and MMII? What is the difference between them?

 How do corporate taxes impact a firm’s value as leverage changes?

 How does leverage affect a firm’s weighted average cost of capital?

 What is trade-off theory? What is pecking order hypothesis?

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