LN Capstru1

Capital Structure: Basic Concepts
15-0
Outline
The Capital-Structure Question and The Pie Theory
Maximizing Firm Value versus Maximizing Stockholder
Interests
Financial Leverage and Firm Value: An Example
Modigliani and Miller: Proposition II (No Taxes)
Taxes
15-1
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
S B
If the goal of the management
of the firm is to make the firm
as valuable as possible, the firm
should pick the debt-equity ratio
that makes the pie as big as Value of the Firm
possible. 15-2
Modigliani & Miller
(Debt policy doesn’t matter)
• When there are no taxes and capital markets
function well, it makes no difference whether the
firm borrows or individual shareholders borrow.
Therefore, the market value of a company does not
depend on its capital structure.
15-3
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
15-4
M&M (Debt Policy Doesn’t Matter)
Assumptions
• By issuing 1 security rather than 2, company
diminishes investor choice. This does not reduce
value if:
– Investors do not need choice, OR
– There are sufficient alternative securities
• Capital structure does not affect cash flows e.g...
– No taxes
– No bankruptcy costs
– No effect on management incentives
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
Interest rate n/a 8%
Shares outstanding 400 240
Share price $50 $50
15-6
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(NI/400) $2.50 $5.00 $7.50
ROA(EBIT/TA) 5% 10% 15%
ROE(NI/EQ) 5% 10% 15%
Current Shares Outstanding = 400 shares

15-7
EPS and ROE Under Proposed Capital
Structure

EBIT $1,000 $2,000 $3,000
Interest 640 640 640
Net income $360 $1,360 $2,360
EPS (NI/240) $1.50 $5.67 $9.83
ROA (EBIT/TA) 5% 10% 15%
ROE (NI/EQ) 3% 11% 20%
Proposed Shares Outstanding = 240 shares

15-8
EPS and ROE Under Both Capital Structures
All-Equity
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
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
15-9
15-10
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 currency, no taxes
Homemade leverage
• Shareholders have an alternative of borrowing on their own
account.
• Homemade Leverage
– When investors use leverage in their own portfolios to
adjust the leverage choice made by the firm.
• 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.
Homemade Leverage (contd..)
• Assume firm decides to use no leverage and
create an all-equity firm.
– An investor who would prefer to hold levered
equity can do so by using leverage in his own
portfolio.
15-12
Homemade Leverage (Debt replicated by
investors): An Example
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 Earnings $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
15-13
• Now assume you use debt, but the investor
would prefer to hold unlevered equity. The
investor can re-create the payoffs of unlevered
equity by buying both the debt and the equity
of the firm. Combining the cash flows of the
two securities produces cash flows identical to
unlevered equity, for a total cost of $2000.
15-14
Homemade Leverage (cont'd)
• In each case, your choice of capital structure
does not affect the opportunities available to
investors.
– Investors can alter the leverage choice of the firm
to suit their personal tastes either by adding more
leverage or by reducing leverage.
– With perfect capital markets, different choices of
capital structure offer no benefit to investors and
does not affect the value of the firm.
11-15
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
15-16
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
15-17
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
15-18
WACC - Leverage, Risk, and the
Cost of Capital
• WACC is the traditional view of capital structure, risk
and return.
 B  S
WACC = r0 =  rB ×  +  rS × 
 V  V
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
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 rWACC = × rB + × rS
B+S B+S
rB rB
B
Debt-to-equity Ratio S
Leverage and Returns
Market Value Balance Sheet example
Asset Value 100 Debt (B) 30

Equity (S) 70
Asset Value 100 Firm Value (V) 100
rB = 7.5% rS = 15%
Overall cost of capital is:
 B   B 
rWACC =  rB × +
  S
r × 
 B + S   B + S 
 30   70 
rWACC =  .075 × +
  . 15 ×  = 12.75%
 100   100 
Leverage and Returns
If firm issues additional 10 of debt and used cash to
repurchase 10 of equity?
What happens to Rs when debt costs rise?
Asset Value 100 Debt (B) 40
Equity (S) 60
Asset Value 100 Firm Value (V) 100
rB = 7.5% changes to 7.875% as debtholders

are likely to demand a higher interest rate
 40   60 
rS = ?? .1275 =  .07875 × +
  S
r × 
 100   100 
rS = 16.0%
Leverage, Returns and Beta
 B  S
BWACC = B portfolio =  BB ×  +  BS × 
 V  V
+ (BWACC − BB )
B
BS = BWACC
V
Example - You are 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. The project
cash flows depend on the overall economy and thus contain
market risk. As a result, you demand a 10% risk premium
over the current risk-free interest rate of 5% to invest in this
project.
a) What is the NPV of this investment opportunity?
b) If you finance this project using only equity, how much
would you receive for the project?
15-25
Financing a Firm with Equity
(cont'd)
• Unlevered Equity
– Equity in a firm with no debt
• Because there is no debt, the cash flows of the

unlevered equity are equal to those of the
project. What is the expected return?
Financing a Firm with Debt and
Equity
• Suppose you decide to borrow $500 initially,
in addition to selling equity.
– Because the project’s cash flow will always be
enough to repay the debt, the debt is risk free and
you can borrow at the risk-free interest rate of 5%.
You will owe the debt holders:
• $500 × 1.05 = $525 in one year.
• Levered Equity
– Equity in a firm that also has debt outstanding
11-27
The capital structure question: Is
E><500?
11-28
The Effect of Leverage on Risk and
Return
• Leverage increases the risk of the equity of a
firm.
– Therefore, it is inappropriate to discount the cash
flows of levered equity at the same discount rate
of 15% that you used for unlevered equity.
Investors in levered equity will require a higher
expected return to compensate for the increased
risk.
11-29
Financing a Firm
with Debt and Equity (cont'd)
• Modigliani and Miller argued that with perfect
capital markets, the total value of a firm
should not depend on its capital structure.
• Because the cash flows of the debt and equity sum to the cash
flows of the project, by the Law of One Price the combined
values of debt and equity must be $1000.
– Therefore, if the value of the debt is $500, the

value of the levered equity must be $500.
• E = $1000 – $500 = $500.
11-30
11-31
Capital Structure in Perfect Capital
Markets
• Application: Financing a coffee shop that
costs $24,000 to open
– Expected cash flow is $34,500 at the end of one
year (details in Table 16.1)
– Given the risk, coffee shop should earn 15%
– NPV of the project is -$24,000+$34,500/1.15 =
$6,000
• Finance with equity costing $30,000
• Use some debt
Table 16.1 Returns to Equity in Different Scenarios with
and Without Leverage
Example 16.1 The Risk and Return
of Levered Equity
Problem:
• Suppose you borrow only $6,000 when financing your coffee shop.
• According to Modigliani and Miller, what should the value of the
equity be? What is the expected return?
Figure 16.4 Unlevered Versus
Levered Returns with Perfect
Capital Market
of Levered Equity
Solution:
Plan:
• The value of the firm’s total cash flows does not change: it is still
$30,000. Thus, if you borrow $6000, your firm’s equity will be worth
$24,000. To determine its expected return, we will compute the
cash flows to equity under the two scenarios . The cash flows to
equity are the cash flows of the firm net of the cash flows to debt
(repayment of principal plus interest).
of Levered Equity
Execute:
• The firm will owe debt holders
$6,000 × 1.05 = $6,300 in one year
• Thus, the expected payoff to equity holders is
$34,500 – $6,300 = $28,200,
for a return of
$28,200 / $24,000 – 1 = 17.5%
of Levered Equity
Evaluate:
• While the total value of the firm is unchanged, the firm’s equity in
this case is more risky than it would be without debt, but less risky
than if the firm borrowed $15,000
• To illustrate, note that if demand is weak, the equity holders will
receive $27,000 – $6,300 = $20,700, for a return of
$20,700/$24,000 – 1 = – 13.75%
of Levered Equity
Evaluate (cont’d):
• Compare this return to – 10% without leverage and – 25% if the
firm borrowed $15,000. As a result, the expected return of the
levered equity is higher in this case than for unlevered equity
(17.5% versus 15%), but not as high as in the previous example
(17.5% versus 25% with more leverage)
Example 16.1a The Risk and Return
of Levered Equity
Problem:
• Suppose you borrow $50,000 when financing a coffee shop
which is valued at $75,000. You expect to generate a cash flow
of $75,000 at the end of the year if demand is weak, $84,000
if demand is as expected and $93,000 if demand is strong.
Each scenario is equally likely. The current risk-free interest
rate is 4%, and there’s an 8% risk premium for the risk of the
assets.
• According to Modigliani and Miller, what should the value of
the equity be? What is the expected return?
of Levered Equity
Solution:
Plan:
• The value of the firm’s total cash flows does not change: it is
still $75,000 (expected cash flow of $84,000 discounted at
12%). Thus, if you borrow $50,000, your firm’s equity will be
worth $25,000. To determine its expected return, we will
compute the cash flows to equity under the two scenarios.
The cash flows to equity are the cash flows of the firm net of
the cash flows to debt (repayment of principal plus interest).
of Levered Equity
Execute:
$50,000 × 1.04 = $52,000 in one year.
$84,000 – $52,000 = $32,000,
for a return of
$32,000 / $25,000 – 1 = 28%.
of Levered Equity
Evaluate:
• While the total value of the firm is unchanged, the firm’s equity in this
case is more risky than it would be without debt.
• To illustrate, if demand is weak, the equity holders will receive $75,000 –
$52,000 = $23,000, for a return of $23,000/$25,000 – 1 = – 8%.
• If demand is strong, the equity holders will receive $93,000 – $52,000 =
$41,000, for a return of $41,000/$25,000 – 1 = 64%.
• Without debt, equity holders expect to receive $84,000/75,000 – 1 = 12%.
Example 16.1b The Risk and Return
of Levered Equity
Problem:
• Suppose you borrow $25,000 when financing a coffee shop which is
valued at $75,000. As in Example 16.1a, you expect to generate a
cash flow of $75,000 at the end of the year if demand is weak,
$84,000 if demand is as expected and $93,000 if demand is strong.
Each scenario is equally likely. The current risk-free interest rate is
4%, and there’s an 8% risk premium for the risk of the assets.
• According to Modigliani and Miller, what should the value of the
equity be? What is the expected return?
of Levered Equity
Solution:
Plan:
• The value of the firm’s total cash flows does not change: it is still $75,000
(the expected $84,000 cash flow discounted at 12%). Thus, if you borrow
$25,000, your firm’s equity will be worth $50,000. To determine its
expected return, we will compute the cash flows to equity under the two
scenarios. The cash flows to equity are the cash flows of the firm net of
the cash flows to debt (repayment of principal plus interest).
of Levered Equity
Execute:
$25,000 × 1.04 = $26,000 in one year.
$84,000 – $26,000 = $58,000,
for a return of
$58,000 / $50,000 – 1 = 16%.
of Levered Equity
Evaluate:
• While the total value of the firm is unchanged, the firm’s equity in this
case is more risky than it would be without debt, but less risky than if the
firm borrowed $50,000.
• To illustrate, if demand is weak, the equity holders will receive $75,000 –
$26,000 = $49,000, for a return of $49,000/$50,000 – 1 = – 2%.
• If demand is strong, the equity holders will receive $93,000 – $26,000 =
$67,000, for a return of $67,000/$50,000 – 1 = 34%.
Figure 16.5 WACC and Leverage
with Perfect Capital Markets
Figure 16.5 WACC and Leverage
with Perfect Capital Markets
(cont’d)
Example 16.2 Computing the
Equity Cost of Capital
Problem:
• Suppose you borrow only $6,000 when financing your coffee shop.
According to MM Proposition II, what will your firm’s equity cost of capital
be?
Solution:
Plan:
• Because your firm’s assets have a market value of $30,000, by MM
Proposition I the equity will have a market value of $24,000 = $30,000 –
$6,000. We can use Eq. 16.3 to compute the cost of equity. We know the
unlevered cost of equity is ru = 15%. We also know that rD is 5%.
Execute:
6000
rE = 15% + (15% − 5%) = 17.5%
24, 000
Evaluate:
• This result matches the expected return calculated in Example 16.1 where
we also assumed debt of $6,000. The equity cost of capital should be the
expected return of the equity holders.
Example 16.2a Computing the
Problem:
• Referring back to Example 16.1a, suppose you borrow $50,000 when
financing your coffee shop. According to MM Proposition II, what will your
firm’s equity cost of capital be?
Solution:
Plan:
Execute:
$50,000
rE = 12% + (12% − 4%) = 28%
$25,000
Evaluate:
• This result matches the expected return calculated in Example 16.1a
where we also assumed debt of $50,000. The equity cost of capital should
be the expected return of the equity holders.
Example 16.2b Computing the
Problem:
• Referring back to Example 16.1b, suppose you borrow $25,000 when
financing your coffee shop. According to MM Proposition II, what will your
firm’s equity cost of capital be?
Solution:
Plan:
Execute:
$25,000
rE = 12% + (12% − 4%) = 16%
$50,000
Evaluate:
• This result matches the expected return calculated in Example 16.1b
where we also assumed debt of $25,000. The equity cost of capital should
be the expected return of the equity holders.
The Effect of Leverage
on Risk and Return (cont'd)
• In summary:
– Leverage increases the risk of equity even when
there is no risk that the firm will default.
• Thus, while debt may be cheaper, its use raises the cost
of capital for equity. Considering both sources of capital
together, the firm’s average cost of capital with
leverage is the same as for the unlevered firm.
11-62

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Capital Structure: Basic Concepts

Recession Expected Expansion

Current Shares Outstanding = 400 shares

Recession Expected Expansion

Proposed Shares Outstanding = 240 shares

Financial Leverage and EPS

6.00 Break-even Advantage

Earnings for 40 shares $100 $200 $300

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

Earnings for 24 shares $36 $136 $236

Asset Value 100 Debt (B) 30

rB = 7.5% changes to 7.875% as debtholders

• Because there is no debt, the cash flows of the

– Therefore, if the value of the debt is $500, the

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