CHAPTER 15 CAPITAL STRUCTURE DECISIONS AND MM MODEL Major issues: 1. Financial structure: long-term vs. short-term financing 2.

Optimal capital structure: optimal mix of debt and equit !. "arget capital structure: structure that maximi#es firm$s value I. Measuring the Impact of Financial Le erage %F&
DFL = %change in net profit Q(P V) FC EBIT = = %change in operating profit Q(P V) FC I EBIT I

'atio Measures of Financial &everage - "()* "F++* %",* etc. -eta .mar/et ris/0 II. Le erage Anal!sis of Alternati e Capital "tructures )xample: Financial 1tatements of 'etco* (nc.* %ec. !1* 222! .32220 -alance 1heet
+urrent ,ssets 5et Fixed ,ssets 422 %ebt 422 )quit 1222 2 1222 1222

(ncome statement
1ales +ost of 6oods 1old 6ross 8rofit 1elling and ,dministrative +osts Operating 8rofit "axes .!2:0 5et profit 32*422 1*742 742 942 !22 ;2 212

"he &everage (mpact of 1hareholder$s 'is/ and 'eturn

%ebt 'atio 2: 12: 22: (nterest 'ate 12: 11:
1

'O) 21.22: 22.44: 29.!2:

%F& 1.222 1.2!9 1.27;

!2: 92: 42: <2:

12: 14: 1;: 24:

2<.92: 2=.22: 2=.72: 2<.24:

1.1!< 1.242 1.9<! 2.222

>p to a certain point return increases as leverage increases. ,fter that .debt ? 42:0 return begins to fall @hile ris/ /eeps increasing. ,n )-("-)81 +hart 1ho@ing the (mpact of "@o %ifferent Financing
+apital 1tructure plan .(0 A onl equit ,ll equit .422*222 shares0 32 3422*222 2 2 2 142*222 2 3 !42*222 32 3 2.72 +apital 1tructure plan .((0 A equit B debt .242*222 shares and 3242*222 (nterest0 32 3 422*222 242*222 242*222 .74*2220 74*222 -174*222 174*222 -32 .72 32.72

)-(" (nterest "axes .!2:0 5et (ncome )81

31*222*222 2 !22*222 722*222 31.92

)-(" (nterest "axes .!2:0 5et (ncome )81

3 1*222*222 242*222 224*222 424*222 32.12

(ndifference level of )-(":

2

)81( ? )81((
(EBIT - I I )(1 T) (EBIT - I II )(1 T) = * shares I shares II

solve for )-("C ? 3422*222

-rea/-even level of )-(": )-("CC ? (nterest ? 3242*222 (((. Factors %etermining an Optimal +apital 1tructure Modigliani-Miller .MM0 8roposition ( Modigliani-Miller .MM0 8roposition (( 8roposition ( A "he total value of the firm$s securities can not be changed just b splitting the cash flo@s into different stream. +,8(",& 1"'>+">') (1 ('')&)D,5"E (nvestment in an unlevered firm A 1: of the EU (nvestment 2.21 VU 'eturn 2.21 Profit

(nvestment in a levered firm A 1: of the EL* 1: of DL (nvestment % 2.21 DL ) 2.21 EL "otal: 2.21.DL EL0 ? 2.21VL 'eturn 2.21 Interest 2.21 .Profit-Interest0 2.21 Profit

5.-. -oth strategies offer the same pa off: 1 percent of the firm$s profit. (nvestment in a levered firm A 1: of the EL (nvestment 2.21 EL ? 2.1 .VL - DL0 'eturn 2.21 .Profit-Interest0

(nvestment in an unlevered firm A borro@ing 2.21 DL on our o@n account* and purchase 1: of EU ? VU (nvestment -orro@ing -2.21 DL ) 2.21 VU 'eturn -2.21 (nterest 2.21 8rofit

"otal

2.21 VU -DL

2.21 .Profit-Interest0

5.-. ,gain both strategies offer the same pa off: 1 percent of profit after interest. +onclusion: -oth investments must have the same costs. "herefore* VU must equal VL. 8roposition (( A the expected rate of return on the common stoc/ of a levered firm increases in proportion to the !e"t-e#$it% ratio .%F)0* expressed in mar/et values. )xpected return of assets*
D E r, = rD + rE D+E D+E
r, = E+pecte! operating inco*e (ar)et 'a&$e of a&& sec$rities

* or

* here r, ? r2 A return on unleveled firm$s assets

solve for rE = r, +

D (r, rD ) G E

-onds are ris/-free at lo@ debt level. ,s the level of debt increases* the rates of interest increase. "he ris/-return trade-off is as follo@s:

-eta of firm$s asset is a @eighted average of the betas of the individual securities:
, = portfolio = D % ) + E D D

E = , + ( , D )

D E

I. MM an# Corporate Ta$es 1. (ntroducing the effect of taxes on the capital structure: 8D ."ax 1hields0 =

TC rD D =TC D rD

8roposition (: D& = D> + "+ %

D (1 - T)(r, rD ) E

8roposition ((: rE = r, +

"he firm maximi#es its value b choosing a capital structure that is all debt. 2. (ntroducing the effect of financial distress on the capital structure Dalue of firm ? Dalue if all B 8D .tax shield0 - 8D .costs of )quit financed Financial distress0

+ost of financial distress: ban/ruptc cost or the right to default %irect costs (ndirect costs "he pac/ing order of financing choices: the choice bet@een internal and external financing

"H) "H)O')"(+,& O8"(M>M (1 , M(I OF )J>("K ,5% %)-"E

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