15-0

CHAPTER

Capital Structure:
Basic Concepts

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Chapter Outline
15.1 The Capital-Structure Question and The Pie Theory
15.2 Maximizing Firm Value versus Maximizing
Stockholder Interests
15.3 Financial Leverage and Firm Value: An Example
15.4 Modigliani and Miller: Proposition II (No Taxes)
15.5 Taxes
15.6 Summary and Conclusions

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15-2

The Capital-Structure Question

and The Pie Theory
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 management S B
of the firm is to make the firm
as valuable as possible, the the
firm should pick the debt-equity
ratio that makes the pie as big
as possible. Value of the Firm
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15-3

The Capital-Structure Question

There are really 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?

As it turns out, changes in capital structure benefit the

stockholders if and only if the value of the firm
increases.
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15-4

Financial Leverage, EPS, and ROE

Consider an all-equity firm that is considering going
into debt. (Maybe some of the original shareholders
want to cash out.)
Current Proposed
Assets $20,000 $20,000
Debt $0 $8,000
$12,000
Equity $20,000
2/3
Debt/Equity ratio 0.00
8%
Interest rate n/a 240
Shares outstanding 400 $50
Share price $50
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15-5

EPS and ROE Under Current Capital

Structure
Recession Expected Expansion
EBIT $1,000 $2,000 $3,000
Interest 0 0 0
Net income $1,000 $2,000 $3,000
EPS $2.50 $5.00 $7.50
ROA 5% 10% 15%
ROE 5% 10% 15%

Current Shares Outstanding = 400 shares

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15-6

EPS and ROE Under Proposed Capital

Structure

Recession Expected Expansion

EBIT $1,000 $2,000 $3,000
Interest 640 640 640
Net income $360 $1,360 $2,360
EPS $1.50 $5.67 $9.83
ROA 5% 10% 15%
ROE 3% 11% 20%

Proposed Shares Outstanding = 240 shares

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15-7

EPS and ROE Under Both Capital Structures

All-Equity
Recession Expected Expansion
EBIT $1,000 $2,000 $3,000
Interest 0 0 0
Net income $1,000 $2,000 $3,000
EPS $2.50 $5.00 $7.50
ROA 5% 10% 15%
ROE 5% 10% 15%
Current Shares Outstanding = 400 shares

Levered
Recession Expected Expansion
EBIT $1,000 $2,000 $3,000
Interest 640 640 640
Net income $360 $1,360 $2,360
EPS $1.50 $5.67 $9.83
ROA 5% 10% 15%
ROE 3% 11% 20%
Proposed Shares Outstanding = 240 shares

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15-8

Financial Leverage and EPS

12.00

10.00 Debt

8.00 No Debt

6.00 Break-even Advantage

EPS

point to debt
4.00

2.00 Disadvantage
to debt
0.00
1,000 2,000 3,000
(2.00) EBIT in dollars, no taxes
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15-9

Assumptions of the Modigliani-Miller

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
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15-10

Homemade Leverage: An Example

Recession Expected Expansion
EPS of Unlevered Firm $2.50 $5.00 $7.50

Earnings for 40 shares $100 $200 $300

Less interest on $800 (8%) $64 $64 $64
Net Profits $36 $136 $236
ROE (Net Profits / $1,200) 3% 11% 20%

We are buying 40 shares of a $50 stock on margin. We get the same

ROE as if we bought into a levered firm.
Our personal debt equity ratio is:
B $800 2
= =
S $1, 200 3
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15-11

Homemade (Un)Leverage:
An Example
Recession ExpectedExpansion
EPS of Levered Firm $1.50 $5.67 $9.83

Earnings for 24 shares $36 $136 $236

Plus interest on $800 (8%) $64 $64 $64
Net Profits $100 $200 $300
ROE (Net Profits / $2,000) 5% 10% 15%
Buying 24 shares of an other-wise identical levered firm along with
the some 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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15-12

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 / SL) (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 capital)
B is the value of debt
SL is the value of levered equity
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The MM Proposition I (No Taxes)

The derivation is straightforward:
Shareholders in a levered firm receive Bondholders receive
EBIT - rB B rB B
Thus, the total cash flow to all stakeholders is
( EBIT - rB B ) + rB B
The present value of this stream of cash flows is VL
Clearly
( EBIT - rB B ) + rB B = EBIT
The present value of this stream of cash flows is VU
\VL = VU
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15-14

The MM Proposition II (No Taxes)

The derivation is straightforward:
B S
rWACC =  rB +  rS Then set rWACC = r0
B +S B +S
B
rB +
S
rS = r0 B +S
multiply both sides by
B +S B +S S
B +S B B +S S B +S
  rB +   rS = r0
S B +S S B +S S
B B +S
 rB + rS = r0
S S

B B B
 rB + rS = r0 + r0 rS = r0 + (r0 - rB )
S S S
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The Cost of Equity, the Cost of Debt, and the Weighted Average Cost
of Capital: MM Proposition II with No Corporate Taxes
Cost of capital: r (%)

B
rS = r0 +  (r0 - rB )
SL

B S
r0 rW ACC =  rB +  rS
B+S B+S

rB rB

B
Debt-to-equity Ratio S
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15-16

The MM Propositions I & II

(with Corporate 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
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 capital)
B is the value of debt
S is the value of levered equity

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15-17

The MM Proposition I (Corp. Taxes)

Shareholders in a levered firm receive Bondholders receive
( EBIT - rB B ) (1 -TC ) rB B
Thus, the total cash flow to all stakeholders is
( EBIT - rB B ) (1 -TC ) + rB B
The present value of this stream of cash flows is VL
Clearly ( EBIT - rB B ) (1 -TC ) + rB B =
= EBIT (1 -TC ) - rB B (1 -TC ) + rB B
= EBIT (1 -TC ) - rB B + rB BTC + rB B
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)

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
rS +
=
rB [1 + -
(1 TC )]r0 + TC rB
S S S
B
Which quickly reduces to =
rS r0 + (1 -TC ) (r0 - rB )
S
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15-19

The Effect of Financial Leverage on the Cost of Debt and

Equity Capital with Corporate Taxes
Cost of capital: r B
(%)
rS = r0 +  ( r0 - rB )
SL

B
rS = r0 +  (1 - TC )  ( r0 - rB )
SL

r0

B SL
rW ACC =  rB  (1 - TC ) +  rS
B+SL B + SL
rB

Debt-to-equity
ratio (B/S)
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15-20

Total Cash Flow to Investors Under

Each Capital Structure with Corp. Taxes
All-Equity
Recession Expected Expansion
EBIT $1,000 $2,000 $3,000
Interest 0 0 0
EBT $1,000 $2,000 $3,000
Taxes (Tc = 35% $350 $700 $1,050

Total Cash Flow to S/H $650 $1,300 $1,950

Levered
Recession Expected Expansion
EBIT $1,000 $2,000 $3,000
Interest ($800 @ 8% ) 640 640 640
EBT $360 $1,360 $2,360
Taxes (Tc = 35%) $126 $476 $826
Total Cash Flow $234+640 $468+$640 $1,534+$640
(to both S/H & B/H): $874 $1,524 $2,174
EBIT(1-Tc)+TCrBB $650+$224 $1,300+$224 $1,950+$224
$874 $1,524 $2,174
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15-21

Total Cash Flow to Investors Under

Each Capital Structure with Corp. Taxes
All-equity firm Levered firm

S G S G

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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Total Cash Flow to Investors Under

Each Capital Structure with Corp. Taxes
All-equity firm Levered firm

S G S G

The sum of the debt plus the equity of the levered firm is
greater than the equity of the unlevered firm.
This is how cutting the pie differently can make the pie
larger: the government takes a smaller slice of the pie!
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15-23

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
Prop 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 )
SL
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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
Prop I holds because shareholders can achieve any
pattern of payouts they desire with homemade leverage.
In a world of taxes, M&M Proposition II states that
leverage increases the risk and return to stockholders.
B
rS = r0 + (1 -TC ) (r0 - rB )
SL
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15-25

Prospectus: Bankruptcy Costs

So far, we have seen M&M suggest that financial
leverage does not matter, or imply that taxes cause the
optimal financial structure to be 100% debt.
In the real world, most executives do not like a capital
structure of 100% debt because that is a state known as
“bankruptcy”.
In the next chapter we will introduce the notion of a
limit on the use of debt: financial distress.
The important use of this chapter is to get comfortable
with “M&M algebra”.

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