Capital Structure: Basic Concepts The Capital-Structure Question and The Pie Theory Maximizing Firm Value versus Maximizing Stockholder Interests Modigliani and Miller: Proposition I (Financial Leverage and Firm Value) Modigliani and Miller: Proposition II (Financial Leverage and Cost of Capital) Taxes The Capital-Structure Question and The Pie Theory 3
The value of a firm is defined to be the
sum of the value of the firm’s debt and the firm’s equity, that is, V = B + S
• If the goal of the Value of the Firm
management of the firm is to make the firm as valuable as S B possible, what is the debt- equity ratio that makes the pie as big as possible? Size of pie, different slices The ratio of debt-to-equity is often referred to as the financial leverage The leverage can be considered as a slicing of pie called firm Size of pie with different slices (or leverage)
B S SS B The Capital-Structure Question 5 There are really two important questions: 1. What is the ratio of debt-to-equity that maximizes the shareholder’s value?
As it turns out, changes in capital structure benefit the
stockholders if and only if the value of the firm increases. The Capital-Structure Question Why should the stockholders care about maximizing firm value? Shouldn’t they be interested in strategies that maximize shareholder value ? As it turns out, changes in capital structure benefit the stockholders if and only if the value of the firm increases. What is the leverage that maximizes the shareholder’s value? What is the relation between the leverage and cost of capital? Financial Leverage, EPS, and ROE : An Example 7
Consider the following change in the leverage: an all-equity
firm goes 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 EPS and ROE Under Current Capital tructure 8
0.00 1,000 2,000 3,000 (2.00) Disadvantag e to debt EBIT EBI in dollars, 11 no taxes The Modigliani-Miller Model 12
MM Assumptions 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 Homemade Leverage: An Example 13 Recession Expected Expansion 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% 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. B $800 2 Our personal debt equity ratio is: S $1,200 3 Homemade (Un)Leverage: An Example 14 Recession Expected 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 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 The MM Propositions I & II (No Taxes) 15 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 The MM Proposition I (No Taxes) 16 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 The MM Proposition II (No Taxes) 17 The derivation is straightforward: B S rWACC rB rS Then set rWACC r0 BS BS B S BS rB rS r0 multiply both sides by BS BS S BS B BS S BS rB rS r0 S BS S BS S B BS 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 18 Corporate Taxes Cost of capital: r (%)
B rS r0 (r0 rB ) SL
B S r0 rWACC rB rS BS BS
rB rB
Debt-to-equity B Ratio S The MM Propositions I & II (with Corporate axes) 19
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 The MM Proposition I (Corp. Taxes)
Shareholders in a levered firm receive Bondholder s receive
20
( 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 Clearly ( EBIT rB B ) (1 TC ) rB B EBIT (1 TC ) rB B (1 TC ) rB B EBIT (1 TC ) rB BTC The MM Proposition I (Corp. Taxes)-cont.
The present value of this stream of cash
flows is VL The present value of the first term is VU The present value of the second term is TC B
VL VU TC B
21 The MM Proposition II (Corp. Taxes) Start with M&M Proposition I with VL VU TC B 22
taxes: Sinc VL eS 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 quickly rS r0 (1 TC ) (r0 rB ) reduces to S The Effect of Financial Leverage on the Cost of Debt and Equity Capital with Corporate Taxes 23
Cost of capital: r B (%) rS r0 (r0 rB ) SL
B rS r0 (1 TC ) (r0 rB ) SL
r0
B SL rWACC rB (1 TC ) rS BSL B SL rB
Debt-to-equity ratio (B/S) Total Cash Flow to Investors Under Each Capital Structure with Corp. Taxes 24 All-Equity 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 Recession Expected Expansion EBIT $1,000 $2,000 $3,000 Interest ($800 @ 8% ) 640 640 640 EBT $360 $1,360 $2,360 Taxes (Tc = 35%) $126 $476 $826 Total Cash Flow $234+640 $468+$640 $1,534+$640 (to both S/H & B/H): $874 $1,524 $2,174 EBIT(1-Tc)+TCrBB $650+$224 $1,300+$224 $1,950+$224 Total Cash Flow to Investors Under 25 Each Capital Structure with Corp. Taxes
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. Total Cash Flow to Investors Under Each Capital Structure with Corp. Taxes 26
All-equity firm Levered firm
S G S G
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! Summary: No Taxes 27 In a world of no taxes, the value of the firm is unaffected by capital structure. This is M&M Proposition I: VL = VU
Prop 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 (r0 rB ) SL Summary: Taxes In a world of taxes, but no bankruptcy costs, the value of the firm 28 increases with leverage. This is M&M Proposition I: VL = VU + TC B Prop I holds because shareholders can achieve any pattern of payouts they desire with homemade leverage. In a world of taxes, M&M Proposition II states that leverage increases the risk and return to stockholders.
So far, we have seen M&M suggest that financial leverage
does not matter, or imply that taxes cause the optimal financial structure to be 100% debt. In the real world, most executives do not like a capital structure of 100% debt because that is a state known as “bankruptcy”. In the next chapter we will introduce the notion of a limit on the use of debt: financial distress. The important use of this chapter is to get comfortable with “M&M algebra”.
