1、Capital Structure Basic Concepts,Key Concepts and Skills,Understand the effect of financial leverage (i.e., capital structure) on firm earnings Understand homemade leverage Understand capital structure theories with and without taxes Be able to compute the value of the unlevered and levered firm,Cha

2、pter 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,15.1 Capital Structure and the Pie,The value of a

3、 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.,Value of the Firm,S,B,S,B,Stockholder

4、Interests,There are two important questions: Why should the stockholders care about maximizing firm value? Perhaps they should be interested in strategies that maximize shareholder value. What is the ratio of debt-to-equity that maximizes the shareholders value? As it turns out, changes in capital s

5、tructure benefit the stockholders if and only if the value of the firm increases.,15.3 Financial Leverage, EPS, and ROE,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,Conside

6、r an all-equity firm that is contemplating going into debt. (Maybe some of the original shareholders want to cash out.),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

7、% 10% 15% Current Shares Outstanding = 400 shares,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,Fin

8、ancial 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,EPS,Debt,No Debt,Break-even point,EBIT in dollars, no taxes,Advantage to debt,Disadvantage to debt,Assumptions of the M&M Model,Homogeneous Expectations Homogeneous Business Risk Classes Perpetual Cash Flows Perfec

9、t 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,Homemade Leverage: An Example,Recession Expected Expansion EPS of Unlevered Firm $2.50 $5.00 $7.50 Earnings for 40 shares $100 $200 $300

10、Less interest on $800 (8%) $64 $64 $64 Net Profits $36 $136 $236 ROE (Net Profits / $1,200) 3.0% 11.3% 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:,Homemade (Un)Leverage: An Example,Rec

11、ession Expected Expansion EPS of Levered Firm $1.50 $5.67 $9.83 Earnings for 24 shares $36 $136 $236 Plus interest on $800 (8%) $64 $64 $64 Net Profits $100 $200 $300 ROE (Net Profits / $2,000) 5% 10% 15% Buying 24 shares of an otherwise identical levered firm along with some of the firms debt gets

12、us to the ROE of the unlevered firm. This is the fundamental insight of M&M,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

13、: VL = VU,15.4 MM Proposition II (No Taxes),Proposition II Leverage increases the risk and return to stockholders Rs = R0 + (B / SL) (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

14、value of debt SL is the value of levered equity,MM Proposition II (No Taxes),The derivation is straightforward:,MM Proposition II (No Taxes),Debt-to-equity Ratio,Cost of capital: R (%),R0,RB,RB,15.5 MM Propositions I & II (With Taxes),Proposition I (with Corporate Taxes) Firm value increases with le

15、verage 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

16、 of capital) B is the value of debt S is the value of levered equity,MM Proposition I (With Taxes),The present value of this stream of cash flows is VL,The present value of the first term is VU The present value of the second term is TCB,MM Proposition II (With Taxes),Start with M&M Proposition I wi

17、th taxes:,Since,The cash flows from each side of the balance sheet must equal:,Divide both sides by S,Which quickly reduces to,The Effect of Financial Leverage,Debt-to-equity ratio (B/S),Cost of capital: R (%),R0,RB,Total Cash Flow to Investors,Recession Expected Expansion EBIT $1,000 $2,000 $3,000

18、Interest 0 0 0 EBT $1,000 $2,000 $3,000 Taxes (Tc = 35%) $350 $700 $1,050 Total Cash Flow to S/H $650 $1,300 $1,950,Recession Expected Expansion EBIT $1,000 $2,000 $3,000 Interest ($800 8% ) 640 640 640 EBT $360 $1,360 $2,360 Taxes (Tc = 35%) $126 $476 $826 Total Cash Flow $234+640 $884+$640 $1,534+

19、$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,All Equity,Levered,Total Cash Flow to Investors,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 great

20、er than the equity of the unlevered firm. This is how cutting the pie differently can make the pie “l(fā)arger.” -the government takes a smaller slice of the pie!,S,G,S,G,B,All-equity firm Levered firm,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 wor