Chapter 16
CAPITAL STRUCTURE: BASIC CONCEPTS
SLIDES
CHAPTER ORGANIZATION
16.1 The Capital Structure Question and the Pie Theory
16.2 Maximizing Firm Value versus Maximizing Stockholder Interests
16.3 Financial Leverage and Firm Value: An Example
Leverage and Returns to Shareholders
The Choice between Debt and Equity
A Key Assumption
16.4 Modigliani and Miller: Proposition II (No Taxes)
16.1 Key Concepts and Skills
16.2 Chapter Outline
16.3 Capital Structure and the Pie
16.4 Stockholder Interests
16.5 Financial Leverage, EPS, and ROE
16.6 EPS and ROE Under Current Structure
16.7 EPS and ROE Under Proposed Structure
16.8 Financial Leverage and EPS
16.9 Assumptions of the M&M Model
16.10 Homemade Leverage: An Example
16.11 Homemade (Un)Leverage: An Example
16.12 MM Proposition I (No Taxes)
16.13 MM Proposition II (No Taxes)
16.14 MM Proposition II (No Taxes)
16.15 MM Proposition II (No Taxes)
16.16 MM Propositions I & II (With Taxes)
16.17 MM Proposition I (With Taxes)
16.18 MM Proposition II (With Taxes)
16.19 The Effect of Financial Leverage
16.20 Total Cash Flow to Investors
16.21 Total Cash Flow to Investors
16.22 Summary: No Taxes
16.23 Summary: Taxes
16.24 Quick Quiz
Risk to Equityholders Rises with Leverage
Proposition II: Required Return to Equityholders Rises With Leverage
MM: An Interpretation
16.5 Taxes
The Basic Insight
Present Value of the Tax Shield
Value of the Levered Firm
Expected Return and Leverage under Corporate Taxes
The Weighted Average Cost of Capital, RWACC,, and Corporate Taxes
Stock Price and Leverage under Corporate Taxes
ANNOTATED CHAPTER OUTLINE
Slide 16.0 Chapter 16 Title Slide
Slide 16.1 Key Concepts and Skills
Slide 16.2 Chapter Outline
16.1. The Capital Structure Question and the Pie Theory
The value of the firm equals the market value of the debt plus the
market value of the equity (firm value identity).
This is just: V = D + E.
Slide 16.3 Capital Structure and the Pie
16.2. Maximizing Firm Value versus Maximizing Stockholder Interests
When the market value of debt is given and constant, any change in the value
of the firm results in an identical change in the value of the equity.
The key to this reasoning lies in the fixed nature of debt and the
residual nature of stock.
Slide 16.4 Stockholder Interests
16.3. Financial Leverage and Firm Value: An Example
.A Leverage and Returns to Shareholders
Example (additional example from the ones in the book and slides)
Current Proposed
Assets $5,000,000 $5,000,000
Debt 0 2,500,000
Equity 5,000,000 2,500,000
D/E ratio 0 1
Share price (assume it does not change with repurchase) $10 $10
Shares outstanding 500,000 250,000
Interest Rate N/A 10%
Current capital structure: No debt
Recession Expected Expansion
EBIT $300,000 $650,000 $1,000,000
Interest Expense 0 0 0
Net Income $300,000 $650,000 $1,000,000
ROE 6% 13% 20%
EPS $0.60 $1.30 $2.00
Proposed capital structure: D/E = 1; interest rate = 10%
Recession Expected Expansion
EBIT $300,000 $650,000 $1,000,000
Interest Expense 250,000 250,000 250,000
Net Income $50,000 $400,000 $750,000
ROE 2% 16% 30%
EPS $0.20 $1.60 $3.00
Lecture Tip: You may wish to provide the following example to better solidify
the students’ understanding of the variability in ROE due to
leverage. Ask the class to consider the difference between ROE
and ROA for an all equity firm given various sales levels. It is easy
to show that ROE = ROA in this case because total equity = total
assets. The substitution of debt for equity results in ROE equaling
ROA at only one level of sales. The fixed interest expense and
lower number of common shares outstanding cause ROE to
change by a larger percentage than the change in ROA, for any
given change in sales.
We can conclude that:
-The effect of financial leverage depends on EBIT.
-Financial leverage increases ROE and EPS when EBIT is greater than the
cross-over point.
-The variability of EPS and ROE is increased with leverage.
Slide 16.5 Financial Leverage, EPS, and ROE
Slide 16.6 EPS and ROE Under Current Structure
Slide 16.7 EPS and ROE Under Proposed Structure
Slide 16.8 Financial Leverage and EPS
Lecture Tip: Many students feel that if a company expects to achieve the
break-even EBIT, it should automatically issue debt. You should
emphasize that this is a break-even point relative to EBIT and EPS.
Beyond this point, EPS will be larger under the debt alternative,
but with additional debt, the firm will have additional financial
risk that would increase the required return on its common stock. A
higher required return might offset the increase in EPS, resulting
in a lower firm value despite the higher EPS. Remember, we do not
want to maximize profit; we want to maximize stockholder wealth.
The M&M models, described in upcoming sections, will offer key
points to make about this relationship.
The “optimal” or “target” capital structure is the debt/equity mix
that simultaneously (a) maximizes the value of the firm, (b)
minimizes the weighted average cost of capital, and (c) maximizes
the market value of the common stock.
Maximizing the value of the firm is the goal of managing capital structure.
Lecture Tip: Students sometimes fail to understand the mechanics
of why “minimizing WACC maximizes firm value.” Remind
students that a firm is just a portfolio of projects, some with
positive NPVs and some with negative NPVs when evaluated at the
WACC. The value of the firm is the sum of the NPVs of its
component projects. We already know that lower discount rates
increase NPVs; consequently, decreasing the WACC will increase
firm value.
.B The Choice between Debt and Equity
We have shown that leverage affects earnings and returns;
however, the question remains, “does it impact the value of the
firm?”
Modigliani and Miller (MM) suggest in a “perfect world” that the
value of the firm does not change in response to changes in capital
structure.
Slide 16.9 Assumptions of the M&M Model
M&M Proposition I – without corporate taxes and bankruptcy costs, the firm
cannot affect its value by altering its capital structure.
This “irrelevance” can be illustrated using homemade leverage,
meaning an investor levers or unlevers an equity security by
trading in her own account through the use of margin (to lever) or
debt investments (to unlever).
Homemade leverage – if all market participants have equal access to the
capital markets, then there is nothing special about corporate
borrowing.
Suppose the firm in the previous example does not change its capital structure.
An investor can replicate the returns of the proposed borrowing by
making her own D/E ratio equal to 1 for the investment. Suppose
an investor buys 50 shares with her own money and 50 shares by
borrowing $500 at 10% interest. The payoffs are:
Recession Expected Expansion
EPS – unlevered firm $0.60 $1.30 $2.00
Earnings for 100 shares $60.00 $130.00 $200.00
Less interest on $500 at 10% 50.00 50.00 50.00
Net earnings $10.00 $80.00 $150.00
Return on investment = net earnings / $500 2% 16% 30%
The investor has been able to convert her return to what she would have
gotten if the company had undertaken the proposed capital
structure and she had just purchased $500 worth of stock.
Suppose instead the firm does switch to the proposed capital structure. An
investor can “unlever” the firm by purchasing both the firm’s stock
and bonds. Consider an investor who invests $250 in the stock and
$250 in the bonds paying 10%. (Note that in both situations, the
investor’s total cash outlay is $500.)
Recession Expected Expansion
EPS – levered firm $0.20 $1.60 $3.00
Earnings for 25 shares 5.00 40.00 75.00
Plus interest on $250 at 10% 25.00 25.00 25.00
Net earnings $30.00 $65.00 $100.00
Return on investment = net earnings / $500 6% 13% 20%
In this case, the investor is able to earn the same return as she
would have earned if the firm did not change capital structure and
she just invested in stock.
Slide 16.10 Homemade Leverage: An Example
Slide 16.11 Homemade (Un)Leverage: An Example
Thus, firm capital structure is irrelevant in the fact that investors
can create the exact level of leverage they desire.
MM Proposition I (No Taxes):
VL = VU
The value of the levered firm is equal to that of the unlevered firm.
Slide 16.12 MM Proposition I (No Taxes)
.C A Key Assumption
Homemade leverage depends on the assumption that investors face
the same borrowing and lending rates as corporations, which may
not hold.
16.4. Modigliani and Miller: Proposition II (No Taxes)
.A Risk to Equityholders Rises with Leverage
Recall from earlier chapters that leverage affects beta. Therefore,
we know that increased leverage increases the risk of equity and,
therefore, the required return.
.B Proposition II: Required Return to Equityholders Rises With
Leverage
M&M Proposition II – a firm’s cost of equity capital is a positive linear
function of its capital structure (still assuming no taxes):
WACC = RWACC = (S/V)RS + (B/V)RB;
RS = R0 + (R0 – RB)(B/S)
As more debt is used, the return on equity increases, but the change in the
proportion of debt versus equity just offsets that increase and the
WACC does not change.
Slide 16.13 –
Slide 16.15 MM Proposition II (No Taxes)
Lecture Tip: Many students wonder why we are even considering a situation
in which taxes do not exist. We are trying to determine what risk-
return trade-off is best for the firm’s stockholders. One way to get
a good understanding of what is relevant to the capital structure
decision is to start in a “perfect world” and then relax
assumptions as we go. By relaxing one assumption at a time, we
can get a better idea of the impact on the capital structure
decision. This is the classic process of “model building” in
economics – start simple and add complexity one step at a time.
Lecture Tip: According to Proposition II,
RE = RA + (RA – RB)(B/S). An alternative explanation is as follows:
In the absence of debt, the required return on equity equals the
return on the firm’s assets, RA. As we add debt, we increase the
variability of cash flows available to stockholders, thereby
increasing stockholder risk.
.C MM: An Interpretation
WACC does not change with capital structure, at least in the
absence of taxes. Thus, firm value does not change.
Lecture Note: You may wish to skip over the distinction between the asset
beta and the equity beta. The key point is that Proposition II shows
that return on equity depends on both business risk and financial
risk.
Business risk – the risk inherent in a firm’s operations. It depends on the
systematic risk of the firm’s assets, and it determines the first
component of the required return on equity.
Financial risk – the extra risk to stockholders that results from
debt financing; it determines the second component of the required
return on equity, (RA – RB)(B/S).
16.5. Taxes
.A The Basic Insight
Tax savings arise from the deductibility of interest. It is the key benefit from
borrowing over issuing equity.
Lecture Tip: “Wall Street Concocts New Tax-Saving Ploy … Treasury Attacks
Clever Way to Let Borrower Deduct Both Principal, Interest.” So
reads a headline from the
November 6, 1997, issue of The Wall Street Journal. How is this
accomplished?
Here is how it works:
“First, the borrower and an investor each put up a certain amount, say $100,
to create a real estate investment trust. The investor, a state
pension fund or other tax-exempt organization, does so by buying
preferred stock in the REIT.
Next, in a typical case, the REIT lends its entire $200 to the borrower. The
borrower pays the interest, but no principal, on the loan. The
REIT, whose income isn’t taxable, passes all this money on to the
investor in the form of high preferred-stock dividends.
These dividends ‘step down’ to almost nothing after 10 years. By then, the
investor has gotten most of its money back. It gets the rest back by
selling the REIT preferred stock to the borrower.
Finally, the REIT is merged into the borrower, giving the
borrower its initial $100 back. The result is that the borrower had
a $100 loan for 10 years, a loan that is now paid off. It could
deduct all payments, since none were principal repayments.”
.B Present Value of the Tax Shield
Annual interest tax savings = B(RB)(TC)
If we assume perpetual debt, then the present value of the interest tax savings
= B(RB)(TC) / RB = BTC
.C Value of the Levered Firm
We also assume perpetual cash flows to the firm. This is done for simplicity,
but the ultimate result is the same even if you use cash flows that
change through time.
Value of an unlevered firm, VU = EBIT(1 – TC)/RU, where RU is the cost of
capital for an all equity firm.
Value of a levered firm, VL = VU + BTC
Slide 16.16 MM Propositions I & II (With Taxes)
Slide 16.17 MM Proposition I (With Taxes)
Lecture Tip: This is a good point at which to digress a bit on the idea that
financing decisions can generate positive NPVs. Put simply, a
positive NPV decision is one for which the firm obtains something
for less than market value. Just as the relative inefficiency of the
physical asset markets makes the search for positive NPV projects
worthwhile, the efficiency of the financial markets makes positive
NPV financing projects unlikely. This can
change in the presence of financial market imperfections; and differential tax
treatment between interest and dividends is a big market
imperfection. Further discussion of the successes and failures of
financial engineering in the last two decades may serve to
illustrate the core concepts: (1) firm value comes largely from the
asset side of the balance sheet and (2) positive NPV financing
projects can also be created, but in general, financing is a zero-
NPV proposition.
.D Expected Return and Leverage under Corporate Taxes
Proposition II With Taxes:
RS = RA + (RA – RB)(B/S)(1-tc)
Slide 16.18 MM Proposition II (With Taxes)
.E The Weighted Average Cost of Capital RWACC and Corporate Taxes
The optimal capital structure is the debt-equity mix that minimizes the WACC
and, therefore, maximizes firm value.
With taxes, as the firm increases debt, the cost of equity increases,
but the deductibility of interest more than offsets this increase,
which reduces the WACC.
Slide 16.19 The Effect of Financial Leverage
Slide 16.20 –
Slide 16.21 Total Cash Flow to Investors
.F Stock Price and Leverage under Corporate Taxes
Firm value, and therefore equity value, increases with the optimal
capital structure. This results in a higher stock price. We should
also note that all value created is awarded to stockholders. The
value of the debt is a contracted amount, i.e., fixed.
Slide 16.22 Summary: No Taxes
Case I – No taxes: firm value is unaffected by the choice of capital
structure
Slide 16.23 Summary: Taxes
Case II – Corporate taxes: firm value is maximized when the firm
uses as much debt as possible due to the interest tax shield
(Bankruptcy costs are addressed in the following chapter.)
Slide 16.24 Quick Quiz