Revised Capital Structure

Chapter 15
Long-Term Financing: An Introduction

 Voting rights
 Proxy voting
 Classes of stock
 Other rights
◦ Share proportionally in declared dividends
◦ Share proportionally in remaining assets during liquidation
◦ Preemptive right – the right to purchase new stock issued,
so as to maintain proportional ownership
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No reproduction or distribution without the prior written consent of McGraw-Hill Education.
15-2
 Dividends
◦ Stated dividend must be paid before dividends can be paid
to common stockholders.
◦ Dividends are not a liability of the firm, and preferred
dividends can be deferred indefinitely.
◦ Most preferred dividends are cumulative – any missed
preferred dividends have to be paid before common
dividends can be paid.
 Preferred stock generally does not carry voting rights.

15-3
 Debt  Equity
◦ Not an ownership interest ◦ Ownership interest
◦ Creditors do not have ◦ Common stockholders
voting rights vote for the board of
◦ Interest is considered a directors and other issues
cost of doing business
and is tax deductible ◦ Dividends are not
◦ Creditors have legal considered a cost of doing
recourse if interest or business and are not tax
principal payments are deductible
missed ◦ Dividends are not a
◦ Excess debt can lead to liability of the firm, and
financial distress and stockholders have no legal
bankruptcy recourse if dividends are
not paid
◦ An all-equity firm cannot
go bankrupt

15-4
 Lines of Credit
◦ Provide a maximum amount the bank is willing to lend
◦ If guaranteed, referred to as a revolving line of credit
 Syndicated Loan
◦ Large money-center banks frequently have more demand
for loans than they have supply.
◦ Small regional banks are often in the opposite situation.
◦ As a result, a lager money center bank may arrange a loan
with a firm or country and then sell portions of the loan to
a syndicate of other banks.

15-5
Uses of Cash Flow Sources of Cash Flow
(100%) (100%)
Capital Internal cash

spending flow (retained
earnings plus Internal
depreciation) cash flow
Financial
deficit
Net
working
capital plus Long-term External
other uses debt and cash flow
equity
15-6
 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 firm’s

management is to make the firm
as valuable as possible, then the S B
firm should pick the debt-equity
ratio that makes the pie as big as
possible.
Value of the Firm

15-7
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?
As it turns out, changes in capital structure only benefit

the stockholders if the value of the firm increases.

15-8
Consider an all-equity firm that is contemplating going into
debt. (Maybe some of the original shareholders want to
cash out.)
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
15-9
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

15-10
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 1.8% 6.8% 11.8%
ROE 3.0% 11.3% 19.7%
Proposed Shares Outstanding = 240 shares

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15-11
12.00
10.00 Debt
8.00 No Debt
6.00 Break-even Advantage

EPS
point to debt
4.00
2.00
0.00
1,000 2,000 3,000
(2.00) Disadvantage EBIT in dollars, no taxes
to debt
15-12
 A firm has capital structure exclusively comprising of ordinary
shares amounting to Rs 10,00,000. The firm now wishes to raise
additional Rs 10,00,000 for expansion. The firm has four
alternative financial plans:
(a) Can raise entire amount from equity capital.

(b) Can raise 50% as equity capital and 50% as 5% debentures.
(c) Can raise entire amount as 6% debentures.
(d) Can raise 50% as equity capital and 50% as 5% preference capital.
Assume existing EBIT is Rs1,20,000 and the tax rate is 35%.

Outstanding ordinary shares 10,000 and the MPS is Rs 100 under
four alternative.
Which financing plan should the firm select?
15-13
Q4. Franklin corporation is comparing two different capital
structures, an all-equity plan (Plan 1) and a levered plan (Plan
2). Under Plan 1, the company would have 315,000 shares of
stock outstanding. Under plan 2, there would be 225,000
shares of stock outstanding and $4.14 million in debt
outstanding. The interest rate on the debt is 10% and there are
no taxes.
a.If EBIT is $750,000, which plan would result in the higher EPS?
b.If EBIT is $1750,000, which plan would result in the higher
EPS?
c.What is the Break-even EBIT?
15-14
Q6. Kolby Corp. is comparing two different capital structures.
Plan 1 would result in 1300 shares of stock and $80640 debt.
Plan 2 would result in 2900 shares of stock and $19200 in
debt. The interest rate on the debt is 10 percent.
a.Ignoring taxes, compare both of these plans to an all-equity

plan assuming that EBIT will be $10500. The all-equity plan
would result in 3,400 shares of stock outstanding. Which of the
three plans has the highest EPS? The lowest?
b.In part (a) what are the break-even levels of EBIT for each plan
as compared to that for an all-equity plan? Is one higher than
the other?
c.Ignoring taxes when will EPS be identical for Plans 1 and 2?
15-15
 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

15-16
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) 3.0% 11.3% 19.7%
We are buying 40 shares of a $50 stock, using $800 in margin.
We get the same ROE as if we bought into a levered firm.
B $800
Our personal debt-equity ratio is:   23
S $ 1, 2 0 0
15-17
RecessionExpected Expansion
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 otherwise identical levered
firm along with some of the firm’s debt gets us to the
ROE of the unlevered firm.
This is the fundamental insight of M&M

15-18
 We can create a levered or unlevered position by
adjusting the trading in our own account.
 This homemade leverage suggests that capital structure
is irrelevant in determining the value of the firm:

VL = VU

15-19
 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

15-20
 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 the
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

15-21
 A company is currently unlevered firm. The
company expects to generate $153.85 EBIT in
perpetuity. The corporate tax rate is 35%,
implying after tax earnings of $100. All earnings
after tax are paid out as dividends.
 The firm is considering a capital restructuring to
allow $200 of debt. The cost of debt capital is
10%. Unlevered firms in the same industry have a
cost of capital of 20%. What will the new value of
this company be?
 VL = VU + TC B = $570
15-22
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.
This is how cutting the pie differently can make the pie “larger.”
-the government takes a smaller slice of the pie!

15-23
 In a world of no taxes, the value of the firm is unaffected by
capital structure.
 This is M&M Proposition I:
VL = V U
 Proposition 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   (R 0  R B )
SL

15-24
 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
 In a world of taxes, M&M Proposition II states that leverage
increases the risk and return to stockholders.
B
RS  R0   (1  T C )  ( R 0  R B )
SL
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15-25
 Bankruptcy risk versus bankruptcy cost
 The possibility of bankruptcy has a negative effect on the value of the firm.
 However, it is not the risk of bankruptcy itself that lowers value.
 Rather, it is the costs associated with bankruptcy.
 It is the stockholders who bear these costs.
Leverage increases the likelihood of bankruptcy. However, bankruptcy

does not, by itself, lower the cash flows to investors. Rather, it is the
costs associated with bankruptcy that lower cash flows.

15-26
 Direct Costs
◦ Legal and administrative costs
 Indirect Costs
◦ Impaired ability to conduct business (e.g., lost sales)

15-27
Assets BV MV Liabilities BV MV
Cash $200 $200 LT bonds $300 $200
Fixed Asset $400 $0 Equity $300 $0
Total $600 $200 Total $600 $200
What happens if the firm is liquidated today?
The bondholders get $200; the shareholders get nothing.

15-28
Q8. Financial Distress: Good time company is a regional chain
department store. It will remain in business for one more year. The
probability of a boom year is 60% and the probability of recession is
40 percent. It is projected that the company will generate a total
cash flow of $148 million in a boom year and $61 million in a
recession. The company’s required debt payment at the end of the
year is $88 million. The market value of the company’s outstanding
debt is $67 million. The company pays no taxes.
a.What payoff do bondholders expect to receive in the event of a
recession?
b.What is the promised return on the company’s debt?
c.What is the expected return on the company’s debt?
15-29
 There is a trade-off between the tax advantage of
debt and the costs of financial distress.
 It is difficult to express this with a precise and
rigorous formula.

15-30
Value of firm (V) Value of firm under
MM with corporate
Present value of tax taxes and debt
shield on debt
VL = VU + TCB
Maximum Present value of

firm value financial distress costs
V = Actual value of firm
VU = Value of firm with no debt
0 Debt (B)
B *
Optimal amount of debt

15-31
 Taxes and bankruptcy costs can be viewed as just
another claim on the cash flows of the firm.
 Let G and L stand for payments to the government
and bankruptcy lawyers, respectively.
V =S+B+G+L
T S
B
L G
 The essence of the M&M intuition is that VT depends on the

cash flow of the firm; capital structure just slices the pie.

15-32
 The firm’s capital structure is optimized where the
marginal subsidy to debt equals the marginal cost.
 Investors view debt as a signal of firm value.
◦ Firms with low anticipated profits will take on a low level of

debt.
◦ Firms with high anticipated profits will take on a high level
of debt.
 A manager that takes on more debt than is optimal in
order to fool investors will pay the cost in the long
run.

15-33
 An individual will work harder for a firm if he is one of the
owners than if he is one of the “hired help.”
 While managers may have motive to partake in perquisites,
they also need opportunity. Free cash flow provides this
opportunity.
 The free cash flow hypothesis says that an increase in
dividends should benefit the stockholders by reducing the
ability of managers to pursue wasteful activities.
 The free cash flow hypothesis also argues that an increase in
debt will reduce the ability of managers to pursue wasteful
activities more effectively than dividend increases.

15-34
Agency costs: Tom Scott is the owner, president, and primary
salesperson for Scott Manufacturing. Because of this, the
company’s profits are driven by the amount of work Tom does.
If he works 40 hours each week, the company’s EBIT will be
$475,000 per year; if he works a 50-hour week, the company’s
EBIT will be $560,000 per year. The company is currently worth
$2.9 million. The company needs a cash infusion of $1.2 million,
and it can issue equity or issue debt with an interest rate of 8
percent. Assume there are no corporate taxes.
a.What are the cash flows to Tom under each scenario?
b.Under which form of financing is Tom likely to work harder?
c.What specific new costs will occur with each form of
financing?
15-35
 Theory stating that firms prefer to issue debt rather
than equity if internal financing is insufficient.
◦ Rule 1
 Use internal financing first
◦ Rule 2
 Issue debt next, new equity last
 The pecking-order theory is at odds with the tradeoff
theory:
◦ There is no target D/E ratio
◦ Profitable firms use less debt
◦ Companies like financial slack

15-36
 Most corporations have low Debt-Asset ratios.
 Changes in financial leverage affect firm value.
◦ Stock price increases with leverage and vice-versa; this is
consistent with M&M with taxes.
◦ Another interpretation is that firms signal good news when they
lever up.
 There are differences in capital structure across industries
and even through time.
 There is evidence that firms behave as if they had a target
Debt-Equity ratio.

15-37
Industry Debt as a % of MV of firm
High Leverage
Textiles 74.34%
Construction 68.52%
Metals & metal products 59.42%
Hotels & tourism 56.03%
Medium Leverage
Chemical 46.34%
Transport/Automobile 45.69%
Food & Beverage 45.37%
Machinery 42.31%
Low Leverage
Footwear 26.83%
Recreational services 24.43%

IT 9.09%
15-38
 Taxes
◦ Since interest is tax deductible, highly profitable firms should use
more debt (i.e., greater tax benefit).
 Types of Assets
◦ The costs of financial distress depend on the types of assets the firm
has. E.g. Investments in L&B, other tangible assets will have lower
cost of financial distress. Or company has investments in R&D will
have higher cost of financial distress.
 Uncertainty of Operating Income
◦ Even without debt, firms with uncertain operating income have a
high probability of experiencing financial distress.

15-39

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Chapter 15

Long-Term Financing: An Introduction

Copyright © 2016 McGraw-Hill Education. All rights reserved.

Copyright © 2016 McGraw-Hill Education. All rights reserved.

Copyright © 2016 McGraw-Hill Education. All rights reserved.

Copyright © 2016 McGraw-Hill Education. All rights reserved.

Capital Internal cash

• If the goal of the firm’s

Value of the Firm

As it turns out, changes in capital structure only benefit

Copyright © 2016 McGraw-Hill Education. All rights reserved.

Copyright © 2016 McGraw-Hill Education. All rights reserved.

Copyright © 2016 McGraw-Hill Education. All rights reserved.

6.00 Break-even Advantage

(a) Can raise entire amount from equity capital.

Assume existing EBIT is Rs1,20,000 and the tax rate is 35%.

a.Ignoring taxes, compare both of these plans to an all-equity

Copyright © 2016 McGraw-Hill Education. All rights reserved.

Copyright © 2016 McGraw-Hill Education. All rights reserved.

is irrelevant in determining the value of the firm:

Copyright © 2016 McGraw-Hill Education. All rights reserved.

Copyright © 2016 McGraw-Hill Education. All rights reserved.

Copyright © 2016 McGraw-Hill Education. All rights reserved.

Copyright © 2016 McGraw-Hill Education. All rights reserved.

Copyright © 2016 McGraw-Hill Education. All rights reserved.

 Copyright © 2016 McGraw-Hill Education. All rights reserved.

Leverage increases the likelihood of bankruptcy. However, bankruptcy

Copyright © 2016 McGraw-Hill Education. All rights reserved.

Copyright © 2016 McGraw-Hill Education. All rights reserved.

What happens if the firm is liquidated today?

The bondholders get $200; the shareholders get nothing.

Copyright © 2016 McGraw-Hill Education. All rights reserved.

Copyright © 2016 McGraw-Hill Education. All rights reserved.

Maximum Present value of

Optimal amount of debt

 The essence of the M&M intuition is that VT depends on the

Copyright © 2016 McGraw-Hill Education. All rights reserved.

◦ Firms with low anticipated profits will take on a low level of

Copyright © 2016 McGraw-Hill Education. All rights reserved.

Copyright © 2016 McGraw-Hill Education. All rights reserved.

Copyright © 2016 McGraw-Hill Education. All rights reserved.

Copyright © 2016 McGraw-Hill Education. All rights reserved.

Food & Beverage 45.37%

Recreational services 24.43%

Copyright © 2016 McGraw-Hill Education. All rights reserved.

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