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Capital Structure: Basic Concepts
Capital Structure: Basic Concepts
Basic Concepts
15-1
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
15-2
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
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 Value of the Firm
as possible. 15-3
The Capital-Structure Question
There are 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?
15-4
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.
15-5
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
15-6
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
15-8
EPS and ROE Under Current Capital
Structure
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
15-11
15-12
10.00 Debt
8.00 No Debt
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.
15-14
Homemade Leverage (Debt replicated by
investors): An Example
Recession Expected Expansion
EPS of Unlevered Firm $2.50 $5.00 $7.50
15-16
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.
11-17
Homemade (Un)Leverage:
An Example
Recession ExpectedExpansion
EPS of Levered Firm $1.50 $5.67 $9.83
BB SS
WACC rr00 rrBB rrSS
WACC
VV VV
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
BS BS
rB rB
B
Debt-to-equity Ratio S
Leverage and Returns
Market Value Balance Sheet example
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
BB
BBSS BBWACC
WACC V
BB
WACC
WACC
B
B B
B
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?
15-27
Financing a Firm with Equity
(cont'd)
• Unlevered Equity
– Equity in a firm with no debt
11-28
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
11-29
The capital structure question: Is
E><500?
11-30
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.
11-31
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.
11-34