• Student Presentations
• Capital Structure Considerations
• Modigliani and Miller – Propositions 1 and 2
• Financial Risk and Expected Returns
• Weighted Average Cost of Capital (WACC)
• After Tax WACC

• Capital structure is mixture of debt and equity
• Firm value is total value of debt plus equity
• Types of equity
– Common
– Preferred
• Types of debt
– Term
– Seniority
– Covenants
• Hybrids
– Convertible bonds

• Capital structure does not matter if:
– Total cash flows do not change based on capital structure
– Markets are perfect
• No frictions (taxes or bankruptcy costs)
• Corporations have no borrowing advantage
• Investors have access to any desired investment
• This means that if the capital markets are providing adequate investment choices, then a firm’s value is independent of the debt ratio

Two firms with exactly the same operating income
Investor owns 1% of each firm’s securities
Firm U is unlevered (all equity)
Dollar Investment
.
01V
U
Dollar Ret urn
.
01

Profits
Firm L is levered (has issued debt)
Debt
Equity
Total
Dollar Investment
.
01D
L
.
01E
L
.
01(D
L

.

01V
L
E
L
)
Dollar Ret urn
.01

Interest
.
01

( Profits Interest)
.
01

Profits
Therefore, the value of the two firms must be equal

• Investor owns 1% of levered firm L
Dollar Investment

.
01E
L
.01(V
L

D
L
)
Dollar Ret urn
.
01

( Profits interest)
• Investor owns 1% of unlevered firm U and borrows an amount equal to 1% of the debt of the levered firm
Borrowing
Equity
Total
Dollar Investment

.
01D
L
.
.
01V
U
01(V
U

D
L
)
Dollar Return
.01

Interest
.
01

Profits
.
01

( Profits Interest)
• Therefore, the value of the two firms must be equal

Modigliani and Miller's Proposition I states that:
A) The market value of any firm is independent of its capital structure
B) The market value of a firm's debt is independent of its capital structure
C) The market value of a firm's common stock is independent of its capital structure
D) All of the above
E) None of the above

• Two streams of cash flow
– Stream A has a present value of PV(A)
– Stream B has a present value of PV(B)
• Value additivity
– The present value of the combined cash flows A+B is PV(A) + PV(B)
• Conservation of value
– Splitting up a cash flow into different parts does not affect the total value of the parts

Table 17.1 – All Equity Financed
Data
Number of shares
Price per share
Market Value of Shares
1,000
$10
$ 10,000
Outcomes
Operating
Earnings
Return
Income per share on shares (%)
A
$500
$.50
5 %
B
1,000
1.00
10
C
1,500
1.50
15
D
2,000
2.00
20

Table 17.2 – Half Debt/Half Equity
Data
Number of shares
Price per share
Market Value of Shares
Market val ue of debt
500
$10
$ 5,000
$ 5,000
Outcomes
Operating
Interest
Equity
Income earnings
Earnings per share
Return on shares (%)
A
$500
$500
$0
$0
0%
B
1,000
500
500
1
10
C
1,500
500
1,000
2
20
D
2 , 000
500
1 , 500
3
30

Table 17.3 – All Equity Firm, Investor Leverage to Borrow Enough to Purchase Another Share
Outcomes
Earnings
LESS on two shares
: Interest @ 10%
Net earnings on investment
Return on $10 investment (%)
A
$1.00
$1.00
$ 0
0%
B
2.00
1.00
1.00
10
C
3.00
1.00
2.00
20
D
4.00
1.00
3.00
30

A) The value of a firm's common stock is unchanged when debt is added to its capital structure
B) The value of any asset is preserved regardless of the nature of the claims against it
C) The value of a firm's debt is unchanged when common stock is added to its capital structure
D) All of the above
E) None of the above

Expected return on assets
 r
A
 expected operating income market val ue of all securities r
A
 r
D

D
D

E
 r
E

D
E

E r
E
 r
A

 r
A
 r
D
 D
E

“The expected rate of return on the common stock of a levered firm increases in proportion to the debt-equity ratio (D/E), expresses in market values; the rate of increase depends on the spread between the expected return on a portfolio of all the firm’s securities and the expected return on the debt.”

• Macbeth Spot Removers – All equity r
E
 r
A
 expected operating income market val ue of all securities

1500

.
15
10 , 000
• Half debt (at 10% interest) and half equity r
E

.
15

.

15

.
10
 5000
5000

.
20 or 20%

Table 17.4 – Financial Leverage Increases Risk
All equity
50 % debt :
Earnings per share ($)
Return on shares
Earnings per share ($)
Return on shares
Operating
$1,500 to
1.50
15%
2
20%
Income
$500
0.50
5%
0
0
Change
$1.00
10%
$2.00
20%

Health and Wealth Company is financed entirely by common stock which is priced to offer a 15% expected return. If the company repurchases 25% of the common stock and substitutes an equal value of debt yielding 6%, what is the expected return on the common stock after refinancing? (Ignore taxes.)
A) 12%
B) 15%
C) 18%
D) 21%
E) None of the above

B
A




B
D

D
V 






B
E

E
V 


B
E

B
A

D 
B
A
E

B
D


A) The expected return on equity is positively related to leverage
B) The required return on equity is a linear function of the firm's debt to equity ratio
C) The risk to equity increases with leverage
D) All of the above
E) None of the above

The beta of an all equity firm is 1.1. If the firm changes its capital structure to 1/3rd debt and 2/3rds equity using
8% debt financing, what will be the beta of the levered firm? The beta of debt is 0.3. (Assume no taxes.)
A) 1.0
B) 1.1
C) 1.5
D) 1.65
E) None of the above

r
r
E r
A r
D
Risk free debt Risky debt
D
E

WACC
 r
A

D
D
V
 r
E
E
V

• Unsatisfied clientele
– Investors want, and will pay a premium for, securities that offer the particular financial instrument they want (risk, timing, etc.)
– Should be a temporary phenomenon
• Government regulation
– Restrictions on interest rates or available investments
• The impact of capital structure on cash flows
– Taxation issues
– Interest paid on corporate debt is a tax deduction

WACC
 r
D


Tc




D
V 




 r
E
E
V 




• Thursday, April 5
– Case 2 – A-Rod
– Case is available in 340 Wohlers
– Be prepared to discuss the case in class
• Tuesday, April 10
– How much should a firm borrow? – Chapter 18
• Thursday, April 12
– Financing and valuation – Chapter 19