McGraw-Hill/Irwin Copyright © 2004by The McGraw-Hill Companies, Inc. All rights reserved. 15-0 Corporate Finance Ross Westerfield Jaffe Seventh Edition.

McGraw-Hill/Irwin Copyright © 2004by The McGraw-Hill Companies, Inc. All rights reserved.

15-1

Corporate Finance Ross Westerfield Jaffe Seventh Edition

Seventh Edition

15Chapter Fifteen

Capital Structure: Basic Concepts


15-2

Chapter Outline

15.1 The Capital-Structure Question and The Pie Theory

15.2 Maximizing Firm Value versus Maximizing Stockholder Interests

15.3 Financial Leverage and Firm Value: An Example

15.4 Modigliani and Miller: Proposition II (No Taxes)

15.5 Taxes

15.6 Summary and Conclusions


15-3

The Capital-Structure Question and The Pie Theory

• The value of a firm is defined to be the sum of the value of the firm’s debt and the firm’s equity.

• V = B + S

• If the goal of the management of the firm is to make the firm as valuable as possible, the the firm should pick the debt-equity ratio that makes the pie as big as possible.

Value of the Firm

S BS BS BS B


15-4

The Capital-Structure Question

There are really 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 shareholder’s value?

As it turns out, changes in capital structure benefit the stockholders if and only if the value of the firm increases.


15-5

Financial Leverage, EPS, and ROE

CurrentAssets $20,000Debt $0Equity $20,000Debt/Equity ratio 0.00Interest rate n/aShares outstanding 400Share price $50

Proposed$20,000$8,000

$12,0002/38%240$50

Consider an all-equity firm that is considering going into debt. (Maybe some of the original shareholders want to cash out.)


15-6

EPS and ROE Under Current Capital 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


15-7

EPS and ROE Under Proposed Capital 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 2% 7% 12%

ROE 3% 11% 20%

Proposed Shares Outstanding = 240 shares


15-8

EPS and ROE Under Both Capital Structures

LeveredRecession Expected Expansion

EBIT $1,000 $2,000 $3,000Interest 640 640 640Net income $360 $1,360 $2,360EPS $1.50 $5.67 $9.83ROA 2% 7% 12%ROE 3% 11% 20%

Proposed Shares Outstanding = 240 shares

All-EquityRecession Expected Expansion

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


15-9

Financial Leverage and EPS

(2.00)

0.00

2.00

4.00

6.00

8.00

10.00

12.00

1,000 2,000 3,000

EP

S

Debt

No Debt

Break-even point

EBI in dollars, no taxes

Advantage to debt

Disadvantage to debt EBIT


15-10

Assumptions of the Modigliani-Miller 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


15-11

The MM Proposition I (No Taxes)

• Proposition I– Firm value is not affected by leverage

VL = VU


15-12

The MM Proposition II (No Taxes)

• Proposition II– Leverage increases the risk and the return to

stockholders

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 levered equity

)( 00 BS rrSB

rr


15-13 The Cost of Equity, the Cost of Debt, and the Weighted Average Cost of Capital: MM Proposition II with No Corporate Taxes

Debt-to-equity Ratio

Cos

t of

capi

tal:

r (%

)

r0

rB

SBWACC rSB

Sr

SB

Br

)( 00 BL

S rrS

Brr

rB

S

B


15-14 The MM Proposition I (with Corporate Taxes)

• Proposition I (with Corporate Taxes)– Firm value increases with leverage

VL = VU + TC B


15-15 The MM Proposition II (with Corporate Taxes)

• Proposition II (with Corporate Taxes)– Some of the increase in equity risk and return is

offset by interest tax shieldrS = 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 debtS is the value of levered equity


15-16The Effect of Financial Leverage on the Cost of Debt and Equity Capital with Corporate Taxes

Debt-to-equityratio (B/S)

Cost of capital: r(%)

r0

rB

)()1( 00 BCL

S rrTS

Brr

SL

LCB

LWACC r

SB

STr

SB

Br

)1(

)( 00 BL

S rrS

Brr


15-17 Total Cash Flow to Investors Under Each Capital Structure with Corp. Taxes

All-EquityRecession Expected Expansion

EBIT $1,000 $2,000 $3,000Interest 0 0 0EBT $1,000 $2,000 $3,000Taxes (Tc = 35%) $350 $700 $1,050

Total Cash Flow to S/H $650 $1,300 $1,950

LeveredRecession Expected Expansion

EBIT $1,000 $2,000 $3,000

Interest ($8000 @ 8% ) 640 640 640

EBT $360 $1,360 $2,360

Taxes (Tc = 35%) $126 $476 $826

Total Cash Flow $234+640 $468+$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



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.

S G S G

B

All-equity firm Levered firm



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!

S G S G

B

All-equity firm Levered firm


15-20

Summary: No Taxes

• In a world of no taxes, the value of the firm is unaffected by capital structure.

• This is MM I:

VL = VU

• MM I holds because shareholders can achieve any pattern of payouts they desire with homemade leverage.

• In a world of no taxes, MM II states that leverage increases the risk and return to stockholders

)( 00 BL

S rrS

Brr


15-21

Summary: Taxes

• In a world of taxes, but no bankruptcy costs, the value of the firm increases with leverage.

• This is MM I:VL = VU + TC B

• MM I holds because shareholders can achieve any pattern of payouts they desire with homemade leverage.

• In a world of taxes, MM II states that leverage increases the risk and return to stockholders.

)()1( 00 BCL

S rrTS

Brr


15-22

Prospectus: Bankruptcy Costs

• So far, MM seems to suggest either 1) financial leverage does not matter or 2) taxes cause the optimal financial structure to be 100% debt.

• In the real world, most executives do not like a capital structure of 100% debt because that is a state known as “bankruptcy”.

• In the next chapter we will introduce the notion of a limit on the use of debt: financial distress.

McGraw-Hill/Irwin Copyright © 2004by The McGraw-Hill Companies, Inc. All rights reserved. 15-0 Corporate Finance Ross Westerfield Jaffe Seventh Edition.

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