A B C D E F G H I

1 4/11/2010
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3 Chapter 26. Tool Kit for Analysis of Capital Structure Theory
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CAPITAL STRUCTURE THEORY: ARBITRAGE PROOFS OF THE MODIGLIANI-MILLER MODELS (Section 26.1)
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9 Modigliani and Miller without Taxes
10 Franco Modigliani and Merton Miller developed a model to examine the impact of debt on firm value. In this
11 first version it is assumed that taxes are zero.
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13 Proposition I.
14 1. The weighted average cost of capital is independent of the firm's capital structure.
15 2. The WACC of a firm with debt is equal to the unlevered cost of equity.
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17 Proposition II.
18 The cost of equity, rsL = rsU + Risk premium = rsU + (rsU -rd)(D/S)
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21 Example of an arbitrage opportunity in zero-growth firms:
22 Suppose that rsL = rsU = 10%. We will show that this leads to an arbitrage opportunity.
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24 Input Data Firm U Firm L
25 No Debt Some Debt
26 EBIT $900,000 $900,000
27 Debt $0 $4,000,000
28 rd NA 7.5%
29 rs 10% 10%
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31 Value
32 of Stock $9,000,000 $6,000,000 Value of Stock = (EBIT - rdD)/rS
33 Total Market
34 Value of Firm $9,000,000 $10,000,000 Value of Firm = Value of Stock + Value of Debt
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36 Compare an investment in L with a "synthetic" investment that duplicates L's leverage using an investment
37 in U and borrowing on the investor's own account.
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39 Borrow amt. Invest $100,000 Portfolio of U,
40 Buy equal to 10% in risk free Debt, and risk Buy
41 10% of U of L's Debt asset free asset 10% of L
42 Cost $900,000 ($400,000) $100,000 $600,000 $600,000
43 Income $90,000 ($30,000) $7,500 $67,500 $60,000
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46 Notice that for the same $600,000 investment, you can get $7,500 more
47 in annual income by forming your own portfolio of U and "home made
48 debt" than you get from an investment in L. MM argue that this won't
49 persist--that investors would buy U and purchase the portfolio, driving
50 up the price of U. At the same time, they would sell their shares of L,
driving down its price.
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 A B C D E F G H I
54 If the cost of equity for L, rsL = rsU + Risk premium = rsU + (rsU -rd)(D/S), then the cost of the portfolio of U and
55 borrowing is equal to the cost of L, and the income of the portfolio of U and borrowing equals the income
56 from L and no arbitrage opportunity exists.
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58 Modigliani and Miller with CorporateTaxes
59 The MM results are different once corporate taxes are added in.
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61 Proposition I ( with corporate taxes)
62 Value of levered firm is the unlevered value plus the debt tax shield: VL = VU + TD
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64 Proposition II (with corporate taxes)
65 The cost of equity to a levered firm is the unlevered cost of equity plus a risk premium:
66 rsL = rsU + (rsU - rd)(1-T)(D/S)
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68 Data for 0 Taxes 0 Taxes 40% Tax Rate 40% Tax Rate
69 Fredrickson No Debt Some Debt No Debt Some Debt
70 EBIT $2,400,000 $2,400,000 $4,000,000 $4,000,000
71 Debt $0 $10,000,000 $0 $10,000,000
72 rd NA 8.0% 8.0% 8.0%
73 rs 12.00% 16.00% 12.00% 13.71% rsL = rsU + (rsU - rd)(1-T)(D/S)
74 Tax Rate 0% 0% 40% 40%
75 Value
76 of Stock $20,000,000 $10,000,000 $20,000,000 $14,000,000 Value of Stock = (EBIT - rdD)(1 - T)/rS
77 Total Market
78 Value of Firm $20,000,000 $20,000,000 $20,000,000 $24,000,000 Value of Firm = Value of Unlevered Firm +T x D
79 WACC 12.00% 12.00% 12.00% 10.00% WACC = (D/V)rd(1-T) + (S/V)rs
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82 Effects of Leverage: MM Models
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84 MM without Taxes
85 D V S D/V rd rs WACC
86 0 $20.00 $20.00 0.00% 8.00% 12.00% 12.00%
87 5 $20.00 $15.00 25.00% 8.00% 13.33% 12.00%
88 10 $20.00 $10.00 50.00% 8.00% 16.00% 12.00%
89 15 $20.00 $5.00 75.00% 8.00% 24.00% 12.00%
90 18 $20.00 $2.00 90.00% 8.00% 48.00% 12.00%
91 20 $20.00 $0.00 100.00% 8.00% 12.00%
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95 MM with Corporate Taxes
96 Tc = 40.00%
97 D V S D/V rd rd x (1-T) rs WACC
98 0 $20.00 $20.00 0.00% 8.00% 4.80% 12.00% 12.00%
99 5 $22.00 $17.00 22.73% 8.00% 4.80% 12.71% 10.91%
100 10 $24.00 $14.00 41.67% 8.00% 4.80% 13.71% 10.00%
101 15 $26.00 $11.00 57.69% 8.00% 4.80% 15.27% 9.23%
102 20 $28.00 $8.00 71.43% 8.00% 4.80% 18.00% 8.57%
103 25 $30.00 $5.00 83.33% 8.00% 4.80% 24.00% 8.00%
104 30 $32.00 $2.00 93.75% 8.00% 4.80% 48.00% 7.50%
105 33.33 $33.33 $0.00 99.99% 8.00% 4.80% 7.20%
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C ost of C apital

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With Taxes
Cost of Capital

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109 60%
Without Taxes
60%
50%
50%
40%
40%
30%
30%
 C ost of C apital
With Taxes

Cost of Capital
A B C D E 60% F G H I
Without Taxes
110 60%
111 50%
112 50%
113 40%
114 40%
115 30%
30%
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121 0% 0%
122 0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100%
123 Debt/Value Ratio Debt/Value Ratio
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129 INTRODUCING PERSONAL TAXES: THE MILLER MODEL (Section 26.2)
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131 Miller extended the original MM model to include personal taxes. If Ts is the personal tax rate, Tc is the corporate tax rate,
132 and Td is the tax rate on interest income, then the new expression for VU is:
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134 EBIT(1  T C ) EBIT(1  T C )(1  T s )
135 VU  
136 rsU rsU (1  T s )
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138 and the value of a levered firm is
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140  (1  TC )(1  Ts ) 
141 V L  VU  1  D
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 (1 - T d ) 
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144 The term in brackets is the gain from leverage.
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146 Tc 34%
147 Ts 15%
148 Td 28%
149 Gain from If the corporate tax rate is 34%, the capital gains rate is 15%,
150 Leverage 22.08% and the ordinary income tax rate is 28%, then the added
151 value to the firm from using $D in debt is 0.22D. I.e. the total
152 firm value increases by about 22% of the amount of debt
153 used.
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155 AN EXTENSION TO THE MM MODEL: NON-ZERO GROWTH AND A RISKY TAX SHIELD (Section 26.4)
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157 Daves and Ehrhardt extended the MM model to include growth. If the firm is growing, then debt will be
158 growing as well, and the value of this (growing) debt tax shield will be larger than MM assumed. Also, since
159 it is not certain that the company will be able to realize the debt tax shield, it is more risky than the risk free
160 rate. It is also more risky than debt, but no more risky than the unlevered firm. Daves and Ehrhardt show
161 that the discount rate on the tax shield, rTS, should be equal to the unlevered return to equity, rsU.
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r d TD
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V L  V U 
r sU  g
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 r d TD
V L  V U 
A B C r sU  g
D E F G H I
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171 rsL  rsU  ( rsU  rd ) D
S
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b L  b U  (b U  bd ) D
S
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SECTION 26.1
SOLUTIONS TO SELF-TEST

An unlevered firm has a value of $100 million. An otherwise identical but levered firm has $30 million
in debt. Under the MM zero-tax model, what is the value of the levered firm? Under the MM corporate
tax model, what is the value of a levered firm if the corporate tax rate is 40%?

Zero-Tax Model

VU = $100

VL = $100.00

Corporate-Tax Model

VU = $100
Corporate tax rate = 40%
Debt = $30

VL = $112.00
SECTION 26.2
SOLUTIONS TO SELF-TEST

An unlevered firm has a value of $100 million. An otherwise identical but levered firm has $30 million in
debt. Under the Miller model, what is the value of a levered firm if the corporate tax rate is 40%, the
personal tax rate on equity is 15%, and the personal tax rate on debt is 35%?

Miller's Model

VU = $100
Corporate tax rate = 40%
Personal tax rate on equity = 15%
Personal tax rate on debt = 35%
Debt = $30

VL = $106.46
 as $30 million in
e is 40%, the
SECTION 26.4
SOLUTIONS TO SELF-TEST

An unlevered firm has a value of $100 million. An otherwise identical but levered firm has $30 million in debt.
Suppose that the firm is growing at a constant rate of 5%, the corporate tax rate is 40%, the cost of debt is 6%, and
the unlevered cost of equity is 8% (assume rsU is the appropriate discount rate for the tax shield). What is the value
of the levered firm? What is the value of the stock? What is the levered cost of equity?

VU = $100
Corporate tax rate = 40%
g= 5%
rd = 6%
rsU = 8%
Debt = $30

VL = $124.00

S= $94.00

rsL = 8.64%
as $30 million in debt.
, the cost of debt is 6%, and
ax shield). What is the value