CAPITAL STRUCTURE
Key Concepts/Questions
• What is Capital Structure?
• Do managers create value by leveraging?
• Understand capital structure theories with and without
taxes
• Estimate value of a(n) levered/unlevered firm
• Relevant Text Book Chapter – “Leverage and Capital
Structure”
More companies are issuing debt…
• RIL has sought share holder approval to raise ₹ 20,000
crore through NCD (June 2018)
• Bharti Airtel to raise ₹ 16,500 crore through debt,
including $ 1 billion in overseas bonds and NCD (March
2018)
• HDFC in talks to raise ₹ 5035 crore through external
commercial borrowings
Defaults also rising..
• Kingfisher airlines
• Reliance communications
• Aircel
• Key Question – is debt good for firms/investors?
Capital Structure and the pie
• Value of firm = V
•V=D+E
• Value of the firm
Capital Structure and "The Pie"
• What is the firm’s
ultimate goal?
• Maximizing shareholder
value?
• Or something else?
Debt
Equity
Imagine you’re a shareholder…
There are two important questions:
1.Why should you care about maximizing firm value? Perhaps
you should be interested in strategies that maximize shareholder
value.
2.What is that particular ratio of debt-to-equity that maximizes the
shareholder’s value?
• Does such a ratio even exist?
Firm Value vs Stockholder Interest
Current
Proposed
I
II
III
Debt
0
500
500
500
Equity
1000
250
500
750
Value
1000
750
1000
1250
Restructured Payoffs
Payoffs to Shareholders
I
II
III
Capital Gains
-750
-500
-250
Dividends
500
500
500
Net Gain/Loss
-250
0
250
As it turns out, changes in capital structure only benefit the stockholders if the
value of the firm increases.
Financial Leverage, EPS and RoE
Current
Assets
Proposed
$ 20000
$ 20000
$0
$ 8000
$ 20000
$ 12000
0
0.67
Interest Rate
8%
8%
Shares Outstanding
400
240
Share Price
$ 50
$ 50
Debt
Equity
D/E Ratio
EPS and RoE: Current Structure
Recession
EBIT
Expected
Expansion
$ 1000
$ 2000
$ 3000
0
0
0
$ 1000
$ 2000
$ 3000
EPS
$ 2.5
$5
$ 7.5
RoA
5%
10%
15%
RoE
5%
10%
15%
Interest
Net Income
Shares
Outstanding
400
EPS and RoE: Proposed Structure
Recession
Expected
Expansion
EBIT
$ 1000
$ 2000
$ 3000
Interest
$ 640
$ 640
$ 640
Net Income
$ 360
$ 1360
$ 2360
EPS
$ 1.5
$ 5.67
$ 9.83
RoA
1.8%
6.8%
11.8%
RoE
3%
11.3%
19.7%
Shares
Outstanding
240
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)
Disadvantage
to debt
2,000
3,000
EBIT in dollars, no taxes
What does this mean?
1.
The impact of financial leverage depends upon EBIT.
2.
Financial leverage increases RoE and EPS when EBIT is
greater than the cross-over point.
3.
The variability of EPS and RoE increases with leverage.
Homemade Leverage
• Assume an unlevered company you’re interested to invest
in has just announced that they are going levered.
• Assume the company is the example described earlier.
• As things stand, the EPS for existing and proposed capital
structures are as follows:
Capital
Structure
Recession
Expected
Expansion
Current
2.5
5
7.5
Proposed
1.5
5.67
9.83
Homemade Leverage
• You want to understand whether the company is really
creating value for you by leveraging.
• As a test, you want to invest $ 1 in the proposed capital
structure i.e. invest $ 1 in the levered equity.
• For investing $ 1 @ $ 50 per share your earnings are as
follows:
EPS
1.5
5.67
9.83
Income from 1
share
1.5
5.67
9.83
Homemade Leverage
• Alternative to investing in the equity of the levered firm, you
also think whether you can replicate the same dollar return by
levering yourself.
• Therefore, you try to invest in the unlevered firm (existing) to
replicate the return of the levered firm.
• As a first step, you need to lever yourself, therefore along with
the $ 50 you have, you need to personally borrow $ x that
matches the capital structure of the new firm.
• As the D/E of new firm is 2/3, currently you have 50 as your
own investment, you need to borrow $ 33.33 (at 8%) so that
overall your personal portfolio has a borrowing of 33.33 and
own money (equity) of 50 matching the D/E of firm.
Homemade Leverage
• Now, you choose to invest all the proceeds i.e. your own $
50 and $ 33.33 borrowed, a total of $ 83.33 into the
unlevered (current) firm’s equity (approx. 1.67 shares)
• For borrowing 33.33, you pay interest of $ 2.67 at 8%.
EPSunlevered
2.5
5
7.5
Earning for
1.67 shares
4.167
8.33
12.50
Interest paid
(2.67)
(2.67)
(2.67)
Overall
gain/loss
1.5
5.67
9.83
Moral of the story
• Without taking any risk, the individual investor on his own
can replicate the dollar return that the firm promises to
provide through change of capital structure.
• If the investor can do on his own (without taking risks)
what the management promise by their capital
restructuring decision, what is the point of such
restructuring?
• In other words, is the firm adding any value to the investor
(in this case shareholder)?
Welcome to MM Theory: 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
MM Theory Proposition 1 (no taxes)
• An individual can create his/her own levered/unlevered
position by adjusting trading in his/her own account.
• This homemade leverage suggests that capital structure
is irrelevant in determining the value of the firm:
• VL = VU
Alternative Example
• Assume there are two companies, U and L, both in the
same industry, having same assets worth ₹ 10,000 and
both earning the same earnings of ₹ 1,000.
• The only difference is, U is an unlevered company while
30% of L’s assets are funded by debt (at 20% interest).
• Assume both companies pay out all the earnings to
shareholders after a year and immediately get liquidated.
• What is the value of both firms?
The balance sheets of U and L
• The balance sheet of U:
Assets
10000
Equity
10000
Debt
3000
Equity
7000
• The balance sheet of L:
Assets
10,000
Value created by U and L
• As both firms earn ₹ 1,000 and immediately distribute the entire earnings to
the shareholders, the Net Income for both firms are as follows:
U
L
Earnings
1000
1000
Interest
0
600
Net Income
1000
400
• Recall the value of a firm is V = D+E, implying the firm creates value for
bondholders/debt providers as coupon/interest payments and to equity
holders as dividends/capital gains.
• In this example, value of U is 1,000 as it has only equity and all earnings are
disbursed as dividends.
• Firm L, on the other hand provides a value of 600 as interest to debt
providers and 400 as dividends to equity holders, a total value of 1000.
• Therefore, we see M&M’s proposition in the absence of taxes, VU = VL
M&M Proposition II (no taxes)
• Proposition II
• Leverage increases the risk and return to stockholders
Rs = R0 + (D / EL) (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)
D is the value of debt
EL is the value of levered equity
• Essentially, once the firm borrows, the equity holders bear
more risk due to the residual nature of equity and demand
more returns to compensate for the risk.
Cost of capital: R (%)
MM Proposition II (No Taxes)
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
Revisiting U and L with taxes
• In the previous example of U and L, assume the tax rate is 30%.
How does the value of both firms change?
U
L
EBIT
1000
1000
Interest
0
600
EAI
1000
400
Taxes (30%)
300
120
EAT
700
280
Value of firm
(D+E)
700
880
• We see that value of L is slightly more than U. This is called the tax
shield effect.
• Effectively, Value of L = 700 + 30%×600 = 880. Due to interest
payment, the tax portion of interest payment is money not paid as
taxes, thus increasing the value of the levered firm.
M&M Propositions I & II with taxes
• 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 + (D/EL)×(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)
D is the value of debt
EL is the value of levered equity
The Effect of Financial Leverage
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)
All Equity
Total Cash Flow to Investors
EBIT
Interest
EBT
Taxes (Tc = 35%)
Levered
Total Cash Flow to S/H
EBIT
Interest ($800 @ 8% )
EBT
Taxes (Tc = 35%)
Total Cash Flow
(to both S/H & B/H):
EBIT(1-Tc)+TCRBB
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
Recession
$1,000
640
$360
$126
$234+640
$874
$650+$224
$874
Expected
$2,000
640
$1,360
$476
$884+$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
Total Cash Flow to Investors
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.
This is how cutting the pie differently can make the pie “larger.”
-the government takes a smaller slice of the pie!
Summary: No Taxes
• In a world of no taxes, the value of the firm is unaffected by
capital structure.
• This is M&M Proposition I:
VL = VU
• 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.
Rs = R0 + (D / EL) (R0 - RB)
Summary: Taxes
• 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
• Proposition 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.
RS = R0 + (D/EL)×(1-TC)×(R0 - RB)
THANK YOU