15-0
Chapter Fifteen
Corporate
Capital Structure:
BasicFinance
Ross Westerfield Jaffe
Concepts


15
Seventh Edition
Seventh Edition
McGraw-Hill/Irwin
Copyright © 2004by The McGraw-Hill Companies, Inc. All rights reserved.
15-1
Chapter Outline
15.1 The Capital-Structure Question and The Pie Theory
15.2 Maximizing Firm Value versus Maximizing
Stockholder Interests
15.3 Financial Leverage and Firm Value: An Example
15.4 Modigliani and Miller: Proposition II (No Taxes)
15.5 Taxes
15.6 Summary and Conclusions
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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
• If the goal of the
management of the firm is to
make the firm as valuable as
possible, the the firm should
pick the debt-equity ratio that
makes the pie as big as
possible.
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S B
Value of the Firm
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15-3
The Capital-Structure Question
There are really 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 benefit the
stockholders if and only if the value of the firm
increases.
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15-4
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.)
Assets
Debt
Equity
Debt/Equity ratio
Interest rate
Shares outstanding
Share price
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Current
$20,000
$0
$20,000
0.00
n/a
400
$50
Proposed
$20,000
$8,000
$12,000
2/3
8%
240
$50
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15-5
EPS and ROE Under Current Capital Structure
EBIT
Interest
Net income
EPS
ROA
ROE
Recession
$1,000
0
$1,000
$2.50
5%
5%
Expected Expansion
$2,000
$3,000
0
0
$2,000
$3,000
$5.00
$7.50
10%
15%
10%
15%
Current Shares Outstanding = 400 shares
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15-6
EPS and ROE Under Proposed Capital Structure
EBIT
Interest
Net income
EPS
ROA
ROE
Recession
$1,000
640
$360
$1.50
2%
3%
Expected Expansion
$2,000
$3,000
640
640
$1,360
$2,360
$5.67
$9.83
7%
12%
11%
20%
Proposed Shares Outstanding = 240 shares
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15-7
EPS and ROE Under Both Capital Structures
All-Equity
Recession
EBIT
$1,000
Interest
0
Net income
$1,000
EPS
$2.50
ROA
5%
ROE
5%
Current Shares Outstanding = 400 shares
Expected
$2,000
0
$2,000
$5.00
10%
10%
Expansion
$3,000
0
$3,000
$7.50
15%
15%
Expected
$2,000
640
$1,360
$5.67
7%
11%
Expansion
$3,000
640
$2,360
$9.83
12%
20%
Levered
EBIT
Interest
Net income
EPS
ROA
ROE
Recession
$1,000
640
$360
$1.50
2%
3%
Proposed Shares Outstanding = 240 shares
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15-8
Financial Leverage and EPS
12.00
Debt
10.00
EPS
8.00
6.00
4.00
No Debt
Advantage
to debt
Break-even
point
2.00
0.00
1,000
(2.00)
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Disadvantage
to debt
2,000
3,000
EBIT
EBI in dollars, no taxes
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15-9
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
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15-10
The MM Proposition I (No Taxes)
• Proposition I
– Firm value is not affected by leverage
VL = VU
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15-11
The MM Proposition II (No Taxes)
• Proposition II
– Leverage increases the risk and the return to
stockholders
B
rS  r0  (r0  rB )
S
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
S is the value of levered equity
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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 (%)
15-12
r0
rS  r0 
rW ACC 
B
 (r0  rB )
SL
B
S
 rB 
 rS
BS
BS
rB
rB
Debt-to-equity Ratio B
S
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15-13
The MM Proposition I
(with Corporate Taxes)
• Proposition I (with Corporate Taxes)
– Firm value increases with leverage
VL = VU + TC B
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15-14
The MM Proposition II
(with Corporate Taxes)
• 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
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15-15
The Effect of Financial Leverage on the Cost of
Debt and Equity Capital with Corporate Taxes
Cost of capital: r
(%)
rS  r0 
rS  r0 
B
 (r0  rB )
SL
B
 (1  TC )  (r0  rB )
SL
r0
rW ACC 
B
SL
 rB  (1  TC ) 
 rS
BSL
B  SL
rB
Debt-to-equity
ratio (B/S)
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15-16
Total Cash Flow to Investors Under
Each Capital Structure with Corp. Taxes
All-Equity
EBIT
Interest
EBT
Taxes (Tc = 35%)
Total Cash Flow to S/H
Recession
$1,000
0
$1,000
$350
Expected
$2,000
0
$2,000
$700
Expansion
$3,000
0
$3,000
$1,050
$650
$1,300
$1,950
Expected
$2,000
640
$1,360
$476
$468+$640
$1,524
$1,300+$224
$1,524
Expansion
$3,000
640
$2,360
$826
$1,534+$640
$2,174
$1,950+$224
$2,174
Levered
EBIT
Interest ($8000 @ 8% )
EBT
Taxes (Tc = 35%)
Total Cash Flow
(to both S/H & B/H):
EBIT(1-Tc)+TCrBB
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Recession
$1,000
640
$360
$126
$234+640
$874
$650+$224
$874
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15-17
Total Cash Flow to Investors Under
Each Capital Structure with Corp. Taxes
All-equity firm
S
G
Levered firm
S
G
B
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.
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15-18
Total Cash Flow to Investors Under
Each Capital Structure with Corp. Taxes
All-equity firm
S
G
Levered firm
S
G
B
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!
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15-19
Summary: No Taxes
• In a world of no taxes, the value of the firm is unaffected by
capital structure.
• This is MM I:
VL = VU
• MM I holds because shareholders can achieve any pattern of
payouts they desire with homemade leverage.
• In a world of no taxes, MM II states that leverage increases
the risk and return to stockholders
B
rS  r0   (r0  rB )
SL
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15-20
Summary: Taxes
• In a world of taxes, but no bankruptcy costs, the value of the
firm increases with leverage.
• This is MM I:
VL = VU + TC B
• MM I holds because shareholders can achieve any pattern of
payouts they desire with homemade leverage.
• In a world of taxes, MM II states that leverage increases the
risk and return to stockholders.
B
rS  r0   (1  TC )  (r0  rB )
SL
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15-21
Prospectus: Bankruptcy Costs
• So far, MM seems to suggest either 1) financial
leverage does not matter or 2) 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.
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