Capital structure I

François Derrien
MGT337

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 The capital-structure question
• The value of a firm is the sum of the value of
the firm’s debt and the firm’s equity:
V=B+S
• Crucial assumption
– Managers’ goal: maximize firm value
– Is it always the case?
• First part of the course
– Good investment decisions increase firm value
• Now
– Can financing decisions increase firm value?
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 The firm is a pie

S B

Value of the Firm

• Can we change the size of the pie by

changing the amount of debt and equity?
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 Road map on capital
structure issues
• Modigliani-Miller
– Benchmark case
– In an ideal world, capital structure does not
matter
• What happens when we consider
– Corporate taxes
– Personal taxes
– Costs of financial distress
• What do we observe?
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The Modigliani-Miller theorem in
the absence of tax
• Hypotheses
– Homogenous expectations
– Perfect capital markets:
• 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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The Modigliani-Miller theorem in
the absence of tax
• Results:
– MM I: the value of the firm does not depend on
its capital structure
– MM II: the required rate of return on equity
increases with the debt/equity ratio of the
company

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 An example
• Consider an all-equity firm, ABC, that is
considering going into debt

Current Proposed
Assets $20,000 $20,000
Debt $0 $8,000
Equity $20,000 $12,000
Debt/Equity ratio 0.00 2/3
Interest rate n/a 8%
Shares outstanding 400 240
Share price $50 $50
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EPS and ROE under the two capital
structures
All-Equity firm
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 firm
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 7
 Homemade leverage
• Consider the 2 strategies below
– Strategy A: buy 40 shares of the levered company
– Strategy B:
1. Borrow $1,333 from a bank (at 8%)
2. Invest $3,333 in the unlevered company (i.e. buy 66,67
shares)
• Strategy B consists in replicating the
debt/equity structure of the levered company
at the investor’s level

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 Homemade leverage (cont.)
Recession Expected Expansion
Strategy A
EPS of levered equity $1.50 $5.67 $9.83
Earnings for 40 shares $60 $226 $393
Initial cost $2,000 $2,000 $2,000
Strategy B
EPS of unlevered equity $2.50 $5.00 $7.50
Earnings for 66.67 shares $167 $333 $500
Interests paid $107 $107 $107
Net Profits $60 $226 $393
Initial cost $2,000 $2,000 $2,000
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 Homemade leverage (cont.)
• Conclusion
– The two strategies have the same cost and the
same gains in the three states of the world
⇒ MM I: the value of the company does not
depend on its capital structure
VU = VL
⇒ If two identical companies which only differ in
their capital structures have different values,
arbitrage opportunities exist

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 Financial leverage and EPS in a
world without tax
12.00
EPS

Debt
10.00
No Debt
8.00

6.00

4.00

2.00

0.00
1,000 2,000 3,000
(2.00) EBIT in dollars 11
 MM proposition II (no taxes)
• The weighted average cost of capital (rWACC) of
the company is independent of its capital
structure B S
rWACC = × rB + × rS = r0
B+S B+S
⇒ MM 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 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 equity
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 MM proposition II (cont.)
Cost of capital: r

B
rS = r0 + × (r0 − rB )
S

B S
r0 rWACC = × rB + × rS
B+S B+S

rB rB

Debt-to-equity ratio
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MM propositions I and II - example
• Company XYZ is all-equity financed. It has an
expected cash flow of $10 million per year in
perpetuity, and 10 million shares. Its cost of capital is
10%. The company plans to open a new plant, which
will cost $4 million, and generate $1 million in
additional cash flow every year
• Write the financial balance sheets of the company
before and after the new investment, depending on
whether the plant is financed with new equity or with
debt (interest rate: 6%)
• Calculate the expected return on equity in both
cases
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 The firm is a pie
• What if we add corporate taxes?

S G

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 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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 MM Proposition I with tax
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
( 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 17
 MM Proposition II with tax
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 reduces to: rS = r0 + × (1 − TC ) × (r0 − rB )
S 18
 The effect of financial leverage on
the cost of debt and equity capital
Cost of capital: r

B
rS = r0 + × (1 − TC ) × (r0 − rB )
SL

r0
B SL
rWACC = × rB × (1 − TC ) + × rS
B+SL B + SL
rB

Debt-to-equity ratio 19
 ABC example with tax
• Consider the ABC example seen in slide 6
• Similarly, assume that the company issues
$8,000 in debt (interest rate: 8%)
• This money is used to repurchase a fraction of
the firm’s equity
• How does this affect the cash flows of the firm?
• How does it affect the financial balance sheet of
the firm?
• How does this affect the value of ABC shares?
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 ABC example with tax
All-Equity firm
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 firm
Recession Expected Expansion
EBIT $1,000 $2,000 $3,000
Interest ($8,000 at 8% ) 640 640 640
EBT $360 $1,360 $2,360
Taxes (Tc = 35%) $126 $476 $826
Total Cash Flow $234+640 $884+$640 $1,534+$640
(to both S/H & B/H): $874 $1,524 $2,174 21
 Where we are
• MM without taxes
– MM I: the value of a company is unchanged when you
change its capital structure: VL=VU
– MM II: the expected return on equity increases with
leverage: rs = r0 + (B/S)x(r0 - rB)
• MM with taxes
– MM I: the value of a company increases when you
change its capital structure: VL=VU+Tc*D
– MM II: the expected return on equity increases with
leverage: rs = r0 + (B/S)x(1-Tc)x(r0 - rB)

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