Captal Structure 1

8/3/2019 Captal Structure 1

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Capital Structure andLong-term Financing

Materi Kuliah FE UNTAR 12 Nov.2010


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The Capital-Structure Question andThe Pie Theory

The value of a firm is defined to be thesum of the value of the firms debt and the

firms equity.

V= B + S

Value of the Firm

S B If the goal of the management ofthe firm is to make the firm as

valuable as possible, the firm shouldpick the debt-equity ratio that makes

the pie as big as possible.


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The Capital-Structure Question

There are really two important questions:1. Why should the stockholders care about

maximizing firmvalue? Perhaps theyshould be interested in strategies thatmaximize shareholder value.

2. What is the ratio of debt-to-equity thatmaximizes the shareholders value?

As it turns out, changes in capitalstructure benefit the stockholders if andonly ifthe value of the firm increases.


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Financial Leverage, EPS,and ROE

Current

Assets RM20,000

Debt RM0

Equity RM20,000

Debt/Equity ratio 0.00Interest rate n/a

Shares outstanding 400

Share price RM50

Proposed

RM20,000

RM8,000

RM12,000

2/38%

240

RM50

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


5/24

EPS and ROE Under CurrentCapital Structure

Recession Expected Expansion

EBIT RM1,000 RM2,000 RM3,000

Interest 0 0 0

Net income RM1,000 RM2,000 RM3,000

EPS RM2.50 RM5.00 RM7.50

ROA 5% 10% 15%ROE 5% 10% 15%

Current Shares Outstanding = 400 shares


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EPS and ROE Under ProposedCapital Structure


EBIT RM1,000 RM2,000 RM3,000

Interest 640 640 640

Net income RM360 RM1,360 RM2,360

EPS RM1.50 RM5.67 RM9.83

ROA 5% 10% 15%

ROE 3% 11% 20%

Proposed Shares Outstanding = 240 shares


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EPS and ROE Under Both Capital Structures

Levered


EBIT RM1,000 RM2,000 RM3,000

Interest 640 640 640

Net income RM360 RM1,360 RM2,360

EPS RM1.50 RM5.67 RM9.83

ROA 5% 10% 15%

ROE 3% 11% 20%

Proposed Shares Outstanding = 240 shares

All-EquityRecession Expected Expansion

EBIT RM1,000 RM2,000 RM3,000

Interest 0 0 0

Net income RM1,000 RM2,000 RM3,000

EPS RM2.50 RM5.00 RM7.50

ROA 5% 10% 15%

ROE 5% 10% 15%Current Shares Outstanding = 400 shares


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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

EPS

Debt

No Debt

Break-even

point

EBI in dollars, no taxes

Advantage

to debt

Disadvantage

to debt EBIT


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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


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Homemade Leverage: An Example

Recession Expected ExpansionEPS of Unlevered Firm RM2.50 RM5.00 RM7.50

Earnings for 40 shares RM100 RM200 RM300

Less interest on RM800 (8%) RM64 RM64 RM64

Net Profits RM36 RM136 RM236

ROE (Net Profits / RM1,200) 3% 11% 20%

We are buying 40 shares of a RM50 stock on margin. We get the

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

32

200,1$

800$

S

B


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Homemade (Un)Leverage: An Example


EPS of Levered Firm RM1.50 RM5.67 RM9.83

Earnings for 24 shares RM36 RM136 RM236

Plus interest on RM800 (8%) RM64 RM64 RM64Net Profits RM100 RM200 RM300

ROE (Net Profits / RM2,000) 5% 10% 15%

Buying 24 shares of an other-wise identical levered firm along with the

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


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The MM Propositions I & II (No Taxes)

Proposition I Firm value is not affected by leverage

VL = VU

Proposition II

Leverage increases the risk and return tostockholders

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)

Bis the value of debt

SL is the value of levered equity


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The MM Proposition I (No Taxes)

UL VV

BrEBITB

receivefirmleveredainrsShareholde

BrB

receivesBondholder

The derivation is straightforward:

BrBrEBITBB

)(

isrsstakeholdealltoflowcashtotaltheThus,

The present value of this stream of cash flows is VL

EBITBrBrEBITBB

)(Clearly

The present value ofthis stream of cash flows is VU


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The MM Proposition II (No Taxes)

The derivation is straightforward:

SBWACCr

SB

Sr

SB

Br

0

setThen rrWACC

0

rr

SB

Sr

SB

B

SB

S

SB bysidesbothmultiply

0rS

SBr

SB

S

S

SBr

SB

B

S

SB

SB

0rS

SBrr

S

B

SB

00 rrS

Brr

S

B

SB )( 00 BS rr

S

Brr


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The Cost of Equity, the Cost of Debt, and the WeightedAverage Cost of Capital: MM Proposition II with No

Corporate Taxes

Debt-to-equity Ratio

Cost

ofcapital:r(%)

r0

rB

SBWACCr

SB

Sr

SB

Br

)( 00 BL

Srr

S

Brr

rB

S

B


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The MM Propositions I & II (with CorporateTaxes)

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

VL = VU+ TCB

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

is offset by 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)

Bis the value of debt

Sis the value of levered equity


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The MM Proposition I (Corp. Taxes)

BTVV CUL

)1()(

receivefirmleveredainrsShareholde

CBTBrEBIT Br

B

receivesBondholder

BrTBrEBITBCB

)1()(

isrsstakeholdealltoflowcashtotaltheThus,

The present value of this stream of cash flows is VL

BrTBrEBITBCB

)1()(Clearly

The present value of the first term is VU

The present value of the second term is TCB

BrTBrTEBITBCBC

)1()1(

BrBTrBrTEBITBCBBC

)1(


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The MM Proposition II (Corp. Taxes)

Start with M&M Proposition I with taxes:

)()1(00 BCS

rrT

S

Brr

BTVV CUL

Since BSVL

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

BCUBSBrTrVBrSr 0

BrTrTBSBrSrBCCBS

0)]1([

Divide both sides by S

BCCBSrT

S

BrT

S

Br

S

Br 0)]1(1[

BTVBSCU

)1(CUTBSV

Which quickly reduces to


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The Effect of Financial Leverage on the

Cost of Debt and Equity Capital

Debt-to-equityratio (B/S)

Cost of capital: r(%)

r0

rB

)()1( 00 BCL

SrrT

S

Brr

S

L

L

CB

L

WACCr

SB

STr

SB

Br

)1(


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Total Cash Flow to Investors UnderEach Capital Structure with Corp. Taxes

All-EquityRecession Expected ExpansionEBIT RM1,000 RM2,000 RM3,000

Interest 0 0 0

EBT RM1,000 RM2,000 RM3,000

Taxes (Tc = 35% RM350 RM700 RM1,050

Total Cash Flow to S/H RM650 RM1,300 RM1,950

Levered


EBIT RM1,000 RM2,000 RM3,000

Interest (RM800 @ 8% ) 640 640 640

EBT RM360 RM1,360 RM2,360

Taxes (Tc = 35%) RM126 RM476 RM826

Total Cash Flow RM234+640 RM468+RM640 RM1,534+RM640

(to both S/H & B/H): RM874 RM1,524 RM2,174

EBIT(1-Tc)+TCrBB RM650+RM224 RM1,300+RM224 RM1,950+RM224

RM874 RM1,524 RM2,174


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Total Cash Flow to Investors UnderEach Capital Structure with Corp. Taxes

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


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Summary: No Taxes

In a world of no taxes, the value of the firm isunaffected by capital structure.

This is M&M Proposition I:

VL = VU

Prop I holds because shareholders can achieveany pattern of payouts they desire withhomemade leverage.

In a world of no taxes, M&M Proposition II statesthat leverage increases the risk and return to

stockholders

)( 00 BL

Srr

SBrr


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Summary: Taxes

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

This is M&M Proposition I:

VL = VU+ TCB Prop I holds because shareholders can achieve

any pattern of payouts they desire withhomemade leverage.

In a world of taxes, M&M Proposition II statesthat leverage increases the risk and return to

stockholders.

)()1( 00 BCL

S rrTS

B

rr


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Prospectus: Bankruptcy Costs

So far, we have seen M&M suggest thatfinancial leverage does not matter, or imply thattaxes cause the optimal financial structure to be100% debt.

In the real world, most executives do not like acapital structure of 100% debt because that is astate known as bankruptcy.

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

The important use of this chapter is to getcomfortable with M&M algebra.

Captal Structure 1

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