Good morning, guys! So Im gonna continue the discussion. Okay, quick review!

________, can you tell us what

have you learned about business risk? Yes, thank you! To determine the optimal capital structure, business
riskis a very important determinant. Firms in different industries have different business risk and so we would
expect capital structure to vary. To explain the factors which makes it different, academics and practitioners
have developed a number of theories of capital structure but today we would focus on the MM approach.
Guys, Id like to introduce to you Professor Franco Modigliani and Merton Miller. They published The cost of
capital, corporate finance, and the theory of investment what has been called the most influential article ever
written. They hypothesized that in perfect markets, it does not matter what capital structure a company uses to
finance its operations and that the market value of a firm is determined by its earning power. Theres a partial
listing of their assumptions on page 480. Guys, please read it. But of course in the real world, there are taxes,
there are brokerage cost, there are bankruptcy cost, there are differences in borrowing cost, there are
information asymmetries, and EBIT is affected by the use of debt. Despite that some of these assumptions are
unrealistic, the Mm approach provided clues about what is required to make capital structure relevant, and
therefore to affect a firms value.
Professor Franco and Professor Merton broke it up in two propositions: Proposition I deals with the value if the
firm and Proposition II deals with WACC. Now, what they did is that they broke it down into three special cases.
Lets look at it under unrealistic assumptions then well start to relax the assumption and make them more
realistic and see how the model holds up.
CASE 1
The first case is the most unrealistic where there are no corporate or personal taxes and no bankruptcy cost.
Proposition I argues that the value of the firm is not going to be affected by changes in the capital structure. A
common way this gets depicted is by using a pizza model. The argument is that no matter how much you slice a
pizza, it still has the same size. And just like the firm, if you change the amount of stock and debt that you use to
finance the operations of the firm, it has no impact on the value of the firm and the reason for that is the cash
flow of the firm do not change and therefore the value or size doesnt change. Proposition II makes an
argument that the WACC of the firm is not affected by the capital structure. We know that WACC is just the
weighted average of the component cost of debt, preferred stock and common equity. From another
perspective, WACC is the average return of equity that shareholders require and return of debt that

WACC = wdrd(1-T) + wprp + wcrs

Re= WACC + (WACC-rd) X wd/we

bondholders require. Lets recall the formula. Now if we add some algebra, we can re-arrange and solve for the
value of re.
Lets try to look at a graph. So this is the cost of capital and here is the debt to equity ratio. Down here we have
the return to debt. Its a horizontal line because the return to debt doesnt change. Here we have the return to
equity and it is sloping upward because as we use more debt, we increase the risk that shareholders face and
therefore they require a higher rate of return. But notice that the weighted average capital stays the same even
when we are using more debt.
We can see that by looking at another part of the equation. We can see that the return on equity has two
components. It has the component that deals with the business risk and it has a component that deals with
financial risk. When we increase the amount of leverage or in the debt equity ratio, you are changing the
financial risk but if you think about it, the business risk hasnt change. Lets try to solve a numerical example.
For example Garbowza Company has a WACC of 15%. The return to debt is 9% and theres an old target capital
structure where debt is 30% and equity is 70%. And we wanna see how that compares if they change their
target to using more debt. So they use 50% debt and 50% equity. So lets substitute it from our equation.
CASE 2
So now lets look at the model where there are corporate taxes but still no bankruptcy cost. We all know that
interest on debt is tax deductible. So when a firm adds debt, it ends up reducing its taxes and what happens
when you reduce your taxes? we increase the cash flow of the firm. Now this will result to a reduction in net
income because you are paying money to the government but you are going to increase your cash flow. So lets
take a look at an example. Here we have the case of unlevered firm and a levered firm. They both have ebit of
1,000 dollars. In the unlevered firm, there is no interest so taxable income is still 1,000. If we assume a tax of
30% so theres 300 dollars of tax so net income is 700. In the levered firm, we have 80 dollars of interest which
means we will have 920 taxable income, multiply it by 30% and well have a tax rate of 276 and a net income of
644. But what were really interested in is the cash flow from asset which is simply ebit minus taxes. so in the
unlevered firm, we will have 700 and in the levered firm we have 724. So you see we have 24 extra dollars in
cash flow. This is what we call interest tax shield. now lets see how it affects the value of the firm by looking at
another graph.
So we see here the value of the unleveraged firm. This horizontal line shows that the value of the firm doesnt
change because you are not using any debt, so its always the same. On the other hand, if the company choses
to use debt the value of the firm increases. This difference is the tax shield. so a firm that uses more debt
actually winds up increasing the value of the firm if there are corporate taxes. now lets remember that we are
not assuming any bankruptcy cost so using more debt doesnt increase the risk of bankruptcy here. So in this
case, if you want the greatest value of the firm, you should simply use a hundred percent debt capital structure.
In proposition II which deals with WACC, so heres the case that we had, so here is the return on the
unleveraged firm and we know that the return on equity is upward sloping if theres more debt in the capital
structure, theres going to be more risk so stockholders are going to require a higher return. Now what happens
here is that, it turns out that because of this tax deductibility of the interest payment that the weighted average
cost of capital goes down as we add more debt to our capital structure and it may approach the return on debt
if you use a hundred percent debt because equity would be zero. If you want the lowest cost of capital and you
want the highest value of the firm what should you do? In this case, you should use all debt to finance the firm.
CASE 3
So now lets make it more realistic. Were gonna have taxes and bankruptcy cost. There are couple of different
kinds of bankruptcy cost. Theres the obvious one which is the direct cost. Example are legal and administrative
costs. The cost of bankruptcy is not cheap. You have to hire attorneys. You have to go through the court. Its
very expensive. Enron for example spent around a billion dollars to cover its bankruptcy. Worldcom spent
around 600 million dollars. Bondholders may also loose out. They may not receive the amount of money they
were promised so theres another direct cost. There are also indirect costs of bankruptcy which are actually
larger than the direct cost but are difficult to measure. For example as management spends time dealing with
the bankruptcy, they may take time away in running the business and that may cause sales to go down. Like
what happened with General Motors during the financial crisis when they were going through financial
difficulty. A lot of people were concerned about buying a GM car. Would GM honor their warranty. In US, when
you buy a car, it will have a 3 or 5 year warranty and of course you would expect that to be honored. Now the
government stepped in and said that they ill be the one to honor the warranty. But even that was a bit of
difficulty because part of the reason you buy a car is that the dealership in nearby. The problem was because of
the financial difficulty, dealerships started closing and so people would still drive a long way just to repair or to
claim their warranty. This became a reason why people chose not to buy GM cars. You may also have other
types of concern such as the employees. If you think that the company you are working for is going bankrupt,
you may go and look for another job and the company may loose highly skilled valuable employees.
So lets look at case 3 as the debt-equity ratio goes up, the probability of bankruptcy also goes up. As probability
of bankruptcy goes up, the expected bankruptcy cost goes up. So what happens here? This is one of the most
basic tenants of economics is that there are trade-offs. Using more debt gives you a bigger tax shield but it also
increases the bankruptcy cost which will offset some of that gain and so what will happen? Theres going to be
a point where using too much debt actually decreases the value of the firm and cause WACC to increase. So
lets see how that works out graphically. So again this is the graph were we compared the leveraged and
unleveraged firm. Here the value of the levered firm is equal to the value of the unlevered firm plus the tax
shield. We also found out in case 2 that if there were no bankruptcy cost, the optimal capital structure is to use
100% debt. Now if we add bankruptcy cost. We get this green curve. Now in the early part, adding extra debt
doesnt affect the risk of bankruptcy. At some point, you get to the point where the tax shield offset by the
bankruptcy cost. What happens is that theres an optimal capital structure. What you wanna look at is that this
is the value of the firm so you need this as high was possible. So you want to hit it right in its peak before it
starts to turn down. Up until this point, the tax shield gain as more than the bankruptcy cost. After we get
passed to this point, the bankruptcy cost are greater than the gain from tax shield so you start to lose value.
This is the tax shield and this difference is the bankruptcy cost and at some point, this becomes big enough to
offset this. And you get to the point where youre using too much debt in your capital structure. WACC. At some
point, the benefit from tax shield are offset the additional bankruptcy cost which increase the cost of capital
Signaling theory
Next, Ill be discussing the signaling theory. One of the key assumptions Modigliani and Miller make in their
work is that market information is symmetric, meaning companies and investors have the same information
with respect to the company's future projects/investments. This assumption, however, is not realistic. When
making capital decisions, a company's management should have more information than an investor, which
implies asymmetric information.

A financing decision is a way in which a company can inadvertently signal its prospects to investors. For
example, suppose Newco decides to finance a new project with equity. Newco's additional equity would in fact
dilute stockholder value. Since companies typically try to maximize stockholder value, would an equity offering
be a bad signal? The answer is yes.

There would be some benefit from the project to the stockholders; however, the dilution from the offering
would offset some of that benefit. If a company's prospects are good, management will finance new projects
with other means, such as debt, to avoid giving any negative signals to the market.

In terms of capital structure, management should, and typically does, have more information than an investor,
which implies asymmetric information. Therefore, investors generally view all capital structure decisions as
some sort of signal. For example, let us think of a company that is issuing new equity. If a company issues new
equity, this generally dilutes share value. Since the goal of the firm is generally to maximize shareholder value,
this can be a viewed as a signal that the company is facing liquidity issues or its prospects are dim. Conversely, a
company with strong solvency and good prospects would generally be able to obtain funds through debt, which
would generally take on lower costs of capital than issuing new equity. If a company fails to have debt extended
to it, or the company's credit rating is downgraded, that is also a bad signal to investors. While the issuance of
equity does have benefits, in the sense that investors can take part in potential earnings growth, a company will
usually choose new debt over new equity in order to avoid the possibility of sending a negative signal.