LECTURE15

Lecture 15: 

Lecture 15 Capital Structure

Basic Concepts: 

Basic Concepts Focus on common stock and straight debt as representative financial instruments. We ignore default for now. The market value of the firm is V = B + S. Maximizing total firm value is in the interest of shareholders. Without bankruptcy, a change in firm value (leaving the level of debt and its characteristics unchanged) accrues to share-holders. Alternatively, if a firm borrows to pay a dividend, the increase in debt will reduce the market value of the equity. (dividends paid out) = (change in market value of B) (net value of the transaction to shareholders) = (change in market value of S) + (change in market value of B)

Modigliani-Miller Proposition I (MMI): 

Modigliani-Miller Proposition I (MMI) The firm’s market value is independent of its capital structure, if Investors care only about risks and returns there is perfect competition everyone is price taker firms and investors (using equities as collateral) can borrow and lend at the same rate there is equal access to all relevant information there are no transaction costs or market frictions such as taxes, issue costs or bankruptcy costs All investors share common view of securities returns Capital markets are perfect in the sense that

Proof of the Proposition MMI: 

Proof of the Proposition MMI

Proof of the Proposition MMI (continued): 

Proof of the Proposition MMI (continued)

An Arbitrage argument for MMI: 

An Arbitrage argument for MMI Arbitrage opportunities would exist if the result did not hold :

Example 1: 

Example 1 Trans Am corporation is considering issuing debt to buy back equity. The current and proposed financial structures are given in :

Example 1 (continued): 

Example 1 (continued) Table 2 : Financial consequences of business cycle fluctuations

Example 1 (continued): 

Example 1 (continued) Table 3 : Payoffs under proposed structure versus homemade leverage Recession Expected Expansion Earnings on 200 current shares $1*200 =$200 $3*200 =$600 $5*200 =$1,000 Interest at 10% on $2,000 debt $200 $200 $200 Net income 0 $400 $800

Example 1 (continued): 

Example 1 (continued) The firm faces three probable scenarios as in Table 2. Although both EPS and ROE are are higher under the proposed structure, we cannot conclude it is good for shareholders, because Table 3 compares 100 shares in the levered firm versus 200 shares in unlevered firm and $2,000 debt at 10% interest rate. EPS and ROE are both more variable with leverage. More importantly, a shareholder wanting the net returns under the proposed structure could do so themselves by borrowing. Since the cost and payoffs are the same, the total value is the same.

Modigliani-Miller Proposition II (MMII): 

Modigliani-Miller Proposition II (MMII)

Proof of the Proposition MMII: 

Proof of the Proposition MMII Then we have Figure 1: MM Proposition II (without corporate taxes)

Example 2: 

Example 2 Investment = $5000, with EBIT = $1000 forever, can be financed with equity, or debt and equity.

Example 2 (continued): 

Example 2 (continued) EBIT = I + EBT. Hence the same cash flow packaged as (I+EBT) should have the same risk. That is,

Example 3: 

Example 3 An all-equity firm has $10 million per year expected earnings, paid as dividends of $1 per share on $10 million shares. The cost of capital for this unlevered firm is 10%, so the PV of the cash flow is The firm is considering a project costing $4 million and expected to generate additional cash flow of $1 million in perpetuity beginning next period.

1. All equity finance: 

1. All equity finance

1. All equity finance (continued): 

1. All equity finance (continued)

1. All equity finance (continued): 

1. All equity finance (continued) The share price jumped to $10.60 so that the expected return on equity remains at 10% despite the addition of the new project. Old equity shareholders made capital gains upon announcement.

2. Debt financing: 

2. Debt financing Now suppose the project is financed by borrowing $4 million at 6%, so (annual interest paid) = $240,000

2. Debt financing (continued): 

2. Debt financing (continued) Balance sheet after construction, but before revenue is received

2. Debt financing (continued): 

2. Debt financing (continued) The shareholders will now expect a yearly cash flow of $10 million + $1 million - $240,000 = $ 10,760,000 Equity holders will therefore expect a return of Notice that here (with debt) is higher than in the case of all equity finance.

Effect of Corporate Taxes: 

Effect of Corporate Taxes Increased leverage can increase firms value, since interest reduces corporate taxes, and dividends or retained earnings do not.

Effect of Corporate Taxes (continued): 

Effect of Corporate Taxes (continued) If the firm has constant debt B with interest , after-tax earnings are . With no retained earnings, cash paid to bond and stock holder is,

Effect of Corporate Taxes (continued): 

Effect of Corporate Taxes (continued)

Effect of Corporate Taxes (continued): 

Effect of Corporate Taxes (continued) Figure 2: MM Proposition II (with corporate taxes)

Example 4: 

Example 4

Example 4 (continued): 

Example 4 (continued)

Example 4 (continued): 

Example 4 (continued)

Example 5: 

Example 5

Example 5 (continued): 

Example 5 (continued) As a check, discount the dividend cash flows to stockholders at

Example 6: 

Example 6 A levered firm L in the same business risk class has debt/equity ratio of 1. Use the MM propositions to determine the after tax cost of equity and the weighted average cost of capital for firms U and L.

Example 6 (continued): 

Example 6 (continued)

Example 7: 

Example 7 Firm U is unlevered with EBIT = $2.5 million, tax rate 34% and 10% required return on equity. In MM framework :

Example 7 (continued): 

Example 7 (continued) Suppose there are two firms A and B, identical in all respects to U and L, respectively. What will happen if market value of A is $12 million and of B is $22 million?