Capital Structure Decision
MM propositions
Financial management: lecture 10
Today’s plan


Review what we have learned in the last
lecture
The capital structure decision
•
•
The capital structure without taxes
•
•
MM’s proposition 1
MM’s proposition 2
The capital structure with taxes
•
•
MM’s proposition 1
MM’s proposition 2
Financial management: lecture 10
What have we learned in the
last lecture


In the last lecture, we have discussed
the case in the end of chapter 12, what
have you learned from this case?
In the last lecture, we have also
discussed three forms of market
efficiency, what are they and what is your
understanding of these three forms of
market efficiency?
Financial management: lecture 10
Look at the both sides of a
balance sheet
Asset
Liabilities and equity
Market value of equity
E
Market value of the asset
V
Market value of debt
D
V=E+D
Financial management: lecture 10
Capital structure


Capital structure refers to the mix of debt and
equity in a firm.
We often use D/E or D/V (V=D+E) to indicate
the capital structure of a firm.
•

Usually, the higher the ratio, the more debt a firm has
The capital structure problem for a firm is to
determine what is the maximum amount of
debt a firm should have to maximize the firm’s
value.
Financial management: lecture 10
Does capital structure affect
the firm value?
Equity
Debt
Debt
Equity
Govt.
Slicing the pie doesn’t
affect the total amount
available to debt
holders and equity holders
Slicing the pie can
affect the size of the slice
going to government
Financial management: lecture 10
Equity
wasted
Debt
Govt.
Slicing the pie can
affect the size of the
wasted slice
MM’s proposition 1

Modigliani & Miller
•
•

If the investment opportunity is fixed, there are no
taxes, and capital markets function well, the market
value of a company does not depend on its capital
structure
Based on the above result, any amount of debt is
optimal
How can we understand this?
•
The size of a pizza has nothing to do with how you
slice it.
Financial management: lecture 10
MM’s proposition 2

Modigliani & Miller
• If the investment opportunity is fixed,
•
there
are no taxes, and capital markets function
well, the expected rate of return on the
common stock of a levered firm increases in
proportion to the debt-equity ratio (D/E),
expressed in market values.
The WACC is independent of how the firm is
financed
Financial management: lecture 10
WACC without taxes in MM’s view
r
rE
WACC
rD
D
V
Financial management: lecture 10
M&M (Debt Policy Doesn’t Matter)
Example - River Cruises - All Equity Financed
Data
Number of shares
100,000
Price per share
$10
Market Value of Shares $ 1 million
Outcome
Operating Income
Earnings per share
Return on shares
State of the Economy
Slump
$75,000
$.75
7.5%
Expected
125,000
1.25
12.5%
Boom
175,000
1.75
17.5%
Financial management: lecture 10
M&M (Debt Policy Doesn’t Matter)
Example
cont.
50% debt
Data
Number of shares
50,000
Price per share
$10
Market Value of Shares
$ 500,000
Market val ue of debt
$ 500,000
Outcome
State of the Economy
Slump
Expected
Boom
Operating Income
$75,000 125,000
175,000
Interest
$50,000 50,000
50,000
Equity earnings
$25,000 75,000
125,000
Earnings per share
$.50
1.50
2.50
Return on shares
5%
15%
25%
Financial management: lecture 10
M&M (Debt Policy Doesn’t Matter)
Example - River Cruises - All Equity Financed
- Debt replicated by investors
Outcome
State of the Economy
Earnings on two shares
LESS : Interest @ 10%
Slump
$1.50
$1.00
Expected
2.50
1.00
Boom
3.50
1.00
Net earnings on investment
Return on $10 investment
$.50
5%
1.50
15%
2.50
25%
Financial management: lecture 10
Capital structure and Corporate
Taxes

The use of debt has a lot of implications:
•
•
Financial risk- The use of debt will increase the risk to
share holders and thus Increase the variability of
shareholder returns.
Interest tax shield- The savings resulting from
deductibility of interest payments.
Financial management: lecture 10
An example on Tax shield
You own all the equity of Space Babies Diaper
Co.. The company has no debt. The company’s
annual cash flow is $1,000, before interest and
taxes. The corporate tax rate is 40%. You have
the option to exchange 1/2 of your equity position
for 10% bonds with a face value of $1,000.
Should you do this and why?
Financial management: lecture 10
C.S. & Corporate Taxes
All Equity
EBIT
Interest Pmt
1/2 Debt
1,000
0
Pretax Income
1,000
Taxes @ 40%
400
Net Cash Flow
$600
Financial management: lecture 10
C.S. & Corporate Taxes
All Equity
1/2 Debt
1,000
1,000
0
100
Pretax Income
1,000
900
Taxes @ 40%
400
360
$600
$540
EBIT
Interest Pmt
Net Cash Flow
Financial management: lecture 10
Capital Structure and Corporate
Taxes
All Equity
1/2 Debt
1,000
1,000
0
100
Pretax Income
1,000
900
Taxes @ 40%
400
360
Net Cash Flow
$600
$540
EBIT
Interest Pmt
Total Cash Flow
All Equity = 600
*1/2 Debt = 640
(540 + 100)
Financial management: lecture 10
Capital Structure and tax shield
PV of Tax Shield =
D x rD x Tc
rD
= D x Tc
Example:
Tax benefit = 1000 x (.10) x (.40) = $40
PV of 40 perpetuity = 40 / .10 = $400
PV Tax Shield = D x Tc = 1000 x .4 = $400
Financial management: lecture 10
MM’s proposition 1 with tax


firm value with debt = value of all equity firm +
PV(tax shield)
Based on the above result, the firm should issue all
debt but no equity to maximize the tax shield.
Example,
all equality firm value =600/0.1=6,000
PV( tax shield)=400
firm value=6,400
Financial management: lecture 10
MM’s proposition 2

The weighted average cost of capital is
decreasing with the ratio of D/E, that is
 D 
 E 
WACC  (1  Tc )rdebt 

r
 equity 

DE
DE

Can you understand this intuitively?
Financial management: lecture 10
WACC Graph
Financial management: lecture 10
Financial Distress
Costs of Financial Distress - Costs arising from
bankruptcy or distorted business decisions
before bankruptcy.
Market Value =
Value if all Equity Financed
+ PV Tax Shield
- PV Costs of Financial
Distress
Financial management: lecture 10
Financial distress
Costs of Financial Distress - Costs arising
from bankruptcy or distorted business
decisions before bankruptcy.
Market Value = Value if all Equity Financed
+ PV Tax Shield
- PV Costs of Financial
Distress
Financial management: lecture 10
Optimal Capital structure
Trade-off Theory - Theory that capital structure
is based on a trade-off between tax savings
and distress costs of debt.
Pecking Order Theory - Theory stating that
firms prefer to issue debt rather than equity if
internal finance is insufficient.
Financial management: lecture 10
Financial Distress
Market Value of The Firm
Maximum value of firm
Costs of
financial distress
PV of interest
tax shields
Value of levered firm
Value of
unlevered
firm
Optimal amount
of debt
Debt
Financial management: lecture 10