Capital Structure: Basic Concepts

Capital Structure
Pie model = the sum of the financial claims of the firm
Debt and equity.
Value of the firm “V” = B + S
Where “B” is the market value of the debt
And “S” is the market value of the equity.
Value of Firm

Stocks 40% Bonds 60%

 Capital Structure
Two Questions:

1. Why should the stockholders not prefer the

strategy that maximizes their interests only?
2. What is the ratio of debt to equity that
maximizes the shareholders’ interest?
 Capital Structure
Maximizing Firm Value versus Maximizing
Stockholder Interests.

Original Structure Value of Debt & Equity

after Payment of Dividends
Debt $0 500 500 500
Equity 1,000 750 500 250
 Capital Structure
Payoff to Shareholders after Restructure
I II III
Capital Gain -$250 -500 -750
Dividends 500 500 500
Net gain or $250 0 -$250
loss
 Financial Leverage & Firm Value
Trans Am Corporation currently has no debt in
its capital structure. The firm is considering
issuing debt to buy back some of its equity.
Current Proposed
Assets $8,000 $8,000
Debt $ 0 $4,000
Equity (market & book) $8,000 $4,000
Interest rate 10% 10%
Market Value/share $ 20 $ 20
Shares outstanding 400 200
 Financial Leverage & Firm Value
Trans Am’s Current Capital Structure: No Debt
Recession Expected Expansion
Return on assets (ROA) 5% 15% 25%
Earnings $ 400 $ 1,200 $2,000
Return on Equity (ROE) 5% 15% 25%
Earnings per share (EPS) $1.00 $3.00 $5.00
Trams Am’s Proposed Capital Structure: Debt = $4,000
Recession Expected Expansion
Return on assets (ROA) 5% 15% 25%
Earnings before interest (EBI) $ 400 $ 1,200 $2,000
Interest - 400 - 400 - 400
Earnings after interest $ 0 $ 800 $1,600
Return on Equity (ROE) 0 20% 40%
Earnings per share (EPS) 0 $4.00 $8.00
 Financial Leverage & Firm Value
Modigliani and Miller (MM) Proposition I:
A firm cannot change the total value of its outstanding
securities by changing the proportions of its capital
structure.
OR
The value of the firm is always the same under
different capital structures.
OR
No capital structure is any better or worse than any
other capital structure for the firm’s stockholders.
MM PROPOSITION I (NO TAXES): THE VALUE OF LEVERED
FIRM IS THE SAME AS THE VALUE OF THE UNLEVERED
FIRM. VL = VU
 Financial Leverage & Firm Value
Payoff and Cost to Shareholder of Trans Am
Corporation under the proposed structure and under
the current structure with Homemade Leverage
Strategy A: Buy 100 Shares of Levered Equity:
Recession Expected Expansion
EPS of levered Equity $0 $4 $8
Earnings per 100 shares 0 400 800

Initial Cost = 100 shares@$20 = $2,000

 Financial Leverage & Firm Value
Strategy B: Homemade Leverage:
Recession Expected Expansion
Earnings per 200 shares
In current unlevered
Trans Am $1 X 200 = $3 X 200 $5 X 200
200 600 1,000
Interest @10% on $2,000 -200 -200 -200
Net Earnings $ 0 $ 400 $ 800
Initial Cost = 200 shares@$20 - $2,000 = $2,000
Amount
borrowed
Investor receives the same payoff whether s/he buys shares in
levered corporation (A) or buys shares in an unlevered firm (B)
and borrows on personal account. His/her initial investments is
the same in either case. Thus, the firm neither helps nor hurts
him/her by adding debt to capital structure.
 Financial Leverage & Firm Value
Modigliani and Miller Proposition II (No Taxes)
Risk to Equityholders Rises with Leverage

Required Return to Equityholders Rises with Leverage.

rWACC = B X rB + S X rs
B+S B+S
rB is the interest rate, also called the cost of debt
rs is the expected return on equity or stock, also called
the cost of equity or the required rate of return on equity.
rWACC is the firm’s weighted average cost of capital.
B is the value of the firm’s debt or bonds.
S is the value of the firm’s stock or equity.
 Financial Leverage & Firm Value
We calculate rs for unlevered firm,
the expected earnings for unlevered firm is $1,200.
Expected Earnings after interest = 1,200 = 15%
Equity 8,000
Levered firm rs =
Expected Earnings after interest = 800 = 20%
Equity 4,000
rWACC = B X rB + S X rs
B+S B+S
Unlevered firm = 0 X 0.1 + 8,000 X 0.15 = 0.15 = 15%
8,000 8,000
 Financial Leverage & Firm Value

Levered Firm:
rWACC = 4,000 X 0.1 + 4,000 X 0.20 =
8,000 8,000
= 0.5 X 0.1 + 0.5 X 0.20 = 0.05 + 0.1 = .15 = 15%
An implication of MM Proposition I is that rWACC is
constant for a given firm, regardless of the capital
structure.
 Financial Leverage & Firm Value

If r0 to be the cost of capital for an all – equity firm.

For Trans AM, r0 is calculated as:
r0 = Expected earnings to unlevered firm = 1,200 = 15%
8,000
r0 = rWACC
MM Proposition II states the expected return of equity,
rs, in terms of leverage
rs = r0 + B (r0 – rB)
S
 Financial Leverage & Firm Value
Cost of capital: r
(%)

rs

r0 rWACC

rB
Debt to equity
ratio (B/S)

rs = r0 + B (r0 – rB) = 0.15 + 4000/4000 (0.15-0.1) = 0.15 + 1 X .05 = 0 .20

S = 20%
 Financial Leverage & Firm Value
Example 1:
Acetate Limited has equity with market value of $20
million and debt with a market value of $10 million.
The cost of debt is 14% per annum. Treasury bill that
mature in one year yield 8% per annum, and the
expected return on the market portfolio over the next
year is 18%. The beta of Acetate’s equity is 0.9. The
firm pays no taxes.
a). What is Acetate’s debt-equity ratio?
b). What is firm’s weighted average cost of capital?
c). What is the cost of capital for an otherwise identical
all – equity firm?
 Financial Leverage & Firm Value
MM PROPOSITION I (CORPORATE TAXES)
Value of Levered Firm = Value of Unlevered Firm+ Tax X Value of Debt
VL = VU + TB
Example:
The Water Products Company has a corporate tax rate,
T, of 35% and expected earnings before interest and
taxes (EBIT) of $1 million each year. Its entire earnings
after taxes are paid out as dividends.
The firm is considering two alternative capital
structures. Under plan I, the firm would have no debt in
its capital structure. Under plan II, the firm would have
$4 million of debt, B. The cost of debt, rB , is 10%.
 Financial Leverage & Firm Value
Plan I Plan II
EBIT $1,000,000 $1,000,000
Interest (rBB) 0 (400,000)
EBT = EBIT – rBB 1,000,000 600,000
Taxes (T = 0.35) (350,000) (210,000)
EAT = [(EBIT – rBB) X (1 – T)] 650,000 390,000

Total cash flow to investors ( both stockholders & bondholders) [EBIT

X (1-T) + TrBB]
650,000 650,000+ 140,000
= 790,000
IRS ( Tax Authorities) receives less taxes under plan II ($210,000) than it
does under plan I (350,000). The difference is:
$350,000 – $210,000 = $140,000
 Financial Leverage & Firm Value
Present Value of the Tax Shield
Interest = rB X B
Interest rate Amount borrowed
= 0.10 X 4,000,000
= 400,000 (All this interest is tax deductible)
Whatever the taxable income of the firm would have
been without debt, the taxable income is now $400,000
less with debt.
In the example the tax rate is 0.35, the reduction in
corporate taxes is $140,000 (0.35 x $400,000).
We can write the reduction in corporate taxes
algebraically: T X rB X B
Corporate tax rate $ amount of interest
 Financial Leverage & Firm Value
TrBB = Tax Shield

Present Value of Tax Shield = TrBB = TB

rB
Value of Unlevered Firm = EBIT X (1 – T)
r0
MM Proposition I (corporate taxes)
VL = EBIT X (1 – T) + TrBB = Vu + TB
r0 rB
 Financial Leverage & Firm Value
MM PROPOSITION II (CORPORATE TAXES)

rs = r0 + B X (r0 – rB ) (1 – T)
S