Chapter 14

CAPITAL STRUCTURE: BASIC CONCEPTS

Copyright 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

14-1

KEY CONCEPTS AND SKILLS

Describe and interpret the effect of financial
leverage (i.e., capital structure) on firm earnings
Define and apply homemade leverage
Explain capital structure theories with and
without taxes
Compute the value of the unlevered and levered
firm

14-2

CHAPTER OUTLINE
14.1 The Capital Structure Question and The
Pie Theory
14.2 Maximizing Firm Value versus Maximizing
Stockholder Interests
14.3 Financial Leverage and Firm Value: An
Example
14.4 Modigliani and Miller: Proposition II (No
Taxes)
14.5 Taxes
14-3

14.1 CAPITAL STRUCTURE AND THE

PIE
The value of a firm is defined to be the
sum of the value of the firms debt and the
firms equity.
V=B+S
If the goal of the firms
management is to make the firm
as valuable as possible, then the
firm should pick the debt-equity
ratio that makes the pie as big
as possible.

S B

Value of the Firm

14-4

14.2 STOCKHOLDER INTERESTS

There are two important questions:
1.Why should the stockholders care about
maximizing firm value? Perhaps they should
be interested in strategies that maximize
shareholder value.
2.What is the ratio of debt-to-equity that
maximizes the shareholders value?
As it turns out, changes in capital structure
benefit the stockholders if and only if the
value of the firm increases.
14-5

14.3 FINANCIAL LEVERAGE, EPS, AND

ROE
Consider an all-equity firm that is considering
going into debt. (Maybe some of the original
shareholders want to cash out.)
Current
Assets
$20,000
Debt
$0
Equity
$20,000
Debt/Equity ratio 0.00
Interest rate
n/a
Shares outstanding 400
Share price
$50

Proposed
$20,000
$8,000
$12,000
2/3
8%
240
$50
14-6

EPS AND ROE UNDER CURRENT

STRUCTURE
Recession Expected Expansion
EBIT
$1,000
$2,000
$3,000
Interest
0
0
0
Net income
$1,000
$2,000
$3,000
EPS
$2.50
$5.00
$7.50
ROA
5%
10%
15%
ROE
5%
10%
15%
Current Shares Outstanding = 400 shares

14-7

EPS AND ROE UNDER PROPOSED

STRUCTURE
Recession Expected Expansion
EBIT
$1,000
$2,000
$3,000
Interest
640
640
640
Net income
$360
$1,360
$2,360
EPS
$1.50
$5.67
$9.83
ROA
1.8%
6.8%
11.8%
ROE
3.0%
11.3%
19.7%
Proposed Shares Outstanding = 240 shares

14-8

FINANCIAL LEVERAGE AND EPS

12.00
Debt

10.00

EPS

8.00
6.00
4.00

No Debt

Advantage
to debt

Break-even
point

2.00
0.00
1,000
(2.00)

Disadvantage
to debt

2,000

3,000

EBIT in dollars, no taxes

14-9

ASSUMPTIONS OF THE M&M

MODEL
Homogeneous Expectations
Homogeneous Business Risk Classes
Perpetual Cash Flows
Perfect Capital Markets:
Perfect competition
Firms and investors can borrow/lend at the
same rate
Equal access to all relevant information
No transaction costs
No taxes
14-10

B
$
8
0
2

S1,23

HOMEMADE LEVERAGE: AN EXAMPLE

Recession Expected Expansion

EPS of Unlevered Firm $2.50

Earnings for 40 shares
$100
Less interest on $800 (8%) $64
Net Profits
$36
ROE (Net Profits / $1,200) 3.0%

$5.00
$200
$64
$136
11.3%

$7.50
$300
$64
$236
19.7%

We are buying 40 shares of a $50 stock, using $800 in margin.

We get the same ROE as if we bought into a levered firm.
Our personal debt-equity ratio is:

14-11

HOMEMADE (UN)LEVERAGE: AN
EXAMPLE
Recession Expected Expansion
EPS of Levered Firm
Earnings for 24 shares
Plus interest on $800 (8%)
Net Profits
ROE (Net Profits / $2,000)

$1.50
$36
$64
$100
5%

$5.67
$136
$64
$200
10%

$9.83
$236
$64
$300
15%

Buying 24 shares of an otherwise identical levered firm along

with some of the firms debt gets us to the ROE of the unlevered
firm.
This is the fundamental insight of M&M.

14-12

MM PROPOSITION I (NO TAXES)

We can create a levered or unlevered position by
adjusting the trading in our own account.
This homemade leverage suggests that capital
structure is irrelevant in determining the value of
the firm:

VL = VU

14-13

14.4 MM PROPOSITION II (NO TAXES)

Proposition II
Leverage increases the risk and return to
stockholders
Rs = R0 + (B / S) (R0 - RB)
RB is the interest rate (cost of debt)
RS is the return on (levered) equity (cost of equity)
R0 is the return on unlevered equity (cost of capital)
B is the value of debt
S is the value of equity

14-14

B
S
R

R
T
h
e
n
s
t
R

R
W
A
C
B
S
W
A
C
0

S
B
B
B

R
R

m
u
l
t
i
p
y
b
o
t
h
s
i
d
e
b
y
B
S
0
SB
B
B

S
B

R
B
S
0

S
B

R
B
S
0
SB
B
R

(SR
)
R
0
SS
00S0B

MM PROPOSITION II (NO TAXES)

The derivation is straightforward:

14-15

B
R

(
R

)
S
0B
0
S
B
S
R

R
W
A
C
B
S
SB
B
S

Cost of capital: R (%)

MM PROPOSITION II (NO TAXES)

R0

RB

RB

Debt-to-equity Ratio

14-16

14.5 MM PROPOSITIONS I & II (WITH

TAXES)
Proposition I (with Corporate Taxes)
Firm value increases with leverage
VL = VU + tC B

Proposition II (with Corporate Taxes)

Some of the increase in equity risk and return is offset by
the interest tax shield
RS = R0 + (B/S)(1-tC)(R0 - RB)
RB is the interest rate (cost of debt)
RS is the return on equity (cost of equity)
R0 is the return on unlevered equity (cost of capital)
B is the value of debt
S is the value of equity

14-17

)
I
E
B
TV
(1L
tC)UR
(
B
ttCB

R
B
B
C
B
R
B
B

MM PROPOSITION I (WITH TAXES)

The total cash flow to all stakeholde rs is
( EBIT RB B ) (1 tC ) RB B

The present value of this stream of cash flows is VL

Clearly, ( EBIT RB B) (1 tC ) RB B

The present value of the first term is VU

The present value of the second term is tCB

14-18

t
B
L
U
C
V
S

t
B
L
U
C
V

(
1

)
U
C
R

V
R

t
B
R
S
B
U
0
C
B
S
B

[
S
(
1

)
]

t
R
B
0
C
B
B
R

[1(R
tS

)]R
SR
B
C
0
C
B
S
B
(1tC)(R
)
0
B

MM PROPOSITION II (WITH TAXES)

Start with M&M Proposition I with taxes:
Since

The cash flows from each side of the balance sheet must equal:

Divide both sides by S

Which quickly reduces to

14-19

B
R

(
R

)
S
0B
0
S
t

(
R
)
S01
C
0
B
S
B
R

R
(
1

t
)

R
W
A
C
B
C
SBS

THE EFFECT OF FINANCIAL

LEVERAGE
Cost of capital: R
(%)

R0

RB

Debt-to-equity
ratio (B/S)

14-20

All Equity

TOTAL CASH FLOW TO INVESTORS

EBIT
Interest
EBT
Taxes (tc = 35%)

Recession
$1,000
0
$1,000
$350

Expected
$2,000
0
$2,000
$700

Expansion
$3,000
0
$3,000
$1,050

Levered

Total Cash Flow to S/H

$650
$1,300
$1,950
RecessionExpected
Expansion
EBIT
$1,000$2,000 $3,000
Interest ($8000 @ 8%)
640640
640
EBT
$360$1,360 $2,360
Taxes (tc = 35%)
$126$476
$826
Total Cash Flow
$234+640$884+$640$1,534+$640
(to both S/H & B/H):
$874$1,524 $2,174
EBIT(1-tc)+tCRBB
$650+$224$1,300+$224$1,950+$224
$874$1,524 $2,174

14-21

TOTAL CASH FLOW TO INVESTORS

All-equity firm
S

Levered firm
S

The levered firm pays less in taxes than does the all-equity firm.
Thus, the sum of the debt plus the equity of the levered firm is
greater than the equity of the unlevered firm.
This is how cutting the pie differently can make the pie larger.
-the government takes a smaller slice of the pie!
14-22

B
R

(SR

)
S
0B
0

SUMMARY: NO TAXES

In a world of no taxes, the value of the firm is unaffected by

capital structure.
This is M&M Proposition I:

VL = VU

Proposition I holds because shareholders can achieve any

pattern of payouts they desire with homemade leverage.
In a world of no taxes, M&M Proposition II states that leverage
increases the risk and return to stockholders in proportion
resulting to no change in the net value of the firm.

14-23

B
R
(S1

tC)
(R
)
S
0
0
B

SUMMARY: TAXES

In a world of taxes, but no bankruptcy costs, the

value of the firm increases with leverage.
This is M&M Proposition I:
VL = VU + tC B
Proposition I holds because shareholders can achieve
any pattern of payouts they desire with homemade
leverage.
In a world of taxes, M&M Proposition II states that
leverage increases the risk and return to stockholders.

14-24

QUICK QUIZ
Why should stockholders care about maximizing
firm value rather than just the value of the
equity?
How does financial leverage affect firm value
without taxes? With taxes?
What is homemade leverage?

14-25