15-1 CHAPTER 15 Capital Structure: Basic Concepts McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc All Rights 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 McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc All Rights 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 McGraw-Hill/Irwin Corporate Finance, 7/e S B Value of the Firm © 2005 The McGraw-Hill Companies, Inc All Rights 15-4 The Capital-Structure Question There are really 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 shareholder’s value? As it turns out, changes in capital structure benefit the stockholders if and only if the value of the firm increases McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc All Rights 15-5 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 McGraw-Hill/Irwin Corporate Finance, 7/e Proposed $20,000 $8,000 $12,000 2/3 8% 240 $50 © 2005 The McGraw-Hill Companies, Inc All Rights 15-6 EPS and ROE Under Current Capital Structure EBIT Interest Net income EPS ROA ROE RecessionExpectedExpansion $1,000$2,000$3,000 00 $1,000$2,000$3,000 $2.50$5.00 $7.50 5%10% 15% 5%10% 15% Current Shares Outstanding = 400 shares McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc All Rights 15-7 EPS and ROE Under Proposed Capital Structure EBIT Interest Net income EPS ROA ROE RecessionExpectedExpansion $1,000$2,000$3,000 640640 640 $360$1,360$2,360 $1.50$5.67 $9.83 5%10% 15% 3%11% 20% Proposed Shares Outstanding = 240 shares McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc All Rights 15-8 EPS and ROE Under Both Capital Structures All-Equity Recession EBIT $1,000 Interest Net income $1,000 EPS $2.50 ROA 5% ROE 5% Current Shares Outstanding = 400 shares Levered Recession EBIT $1,000 Interest 640 Net income $360 EPS $1.50 ROA 5% ROE 3% Proposed Shares Outstanding = 240 shares McGraw-Hill/Irwin Corporate Finance, 7/e Expected $2,000 $2,000 $5.00 10% 10% Expansion $3,000 $3,000 $7.50 15% 15% Expected $2,000 640 $1,360 $5.67 10% 11% Expansion $3,000 640 $2,360 $9.83 15% 20% © 2005 The McGraw-Hill Companies, Inc All Rights 15-9 Financial Leverage and EPS 12.00 Debt 10.00 EPS 8.00 6.00 4.00 No Debt Advantage to debt Break-even point Disadvantage to debt 2.00 0.00 1,000 (2.00) McGraw-Hill/Irwin Corporate Finance, 7/e 2,000 3,000 EBIT in dollars, no taxes © 2005 The McGraw-Hill Companies, Inc All Rights 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 McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc All Rights 12 Homemade (Un)Leverage: An Example RecessionExpectedExpansion 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 other-wise identical levered firm along with the some of the firm’s debt gets us to the ROE of the unlevered firm This is the fundamental insight of M&M McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc All Rights 13 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 to stockholders rs = r0 + (B / SL) (r0 - rB) rB is the interest rate (cost of debt) r s is the return on (levered) equity (cost of equity) r is the return on unlevered equity (cost of capital) B is the value of debt SL is the value of levered equity McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc All Rights 14 The MM Proposition I (No Taxes) The derivation is straightforward: Shareholders in a levered firm receive EBIT rB B Bondholders receive rB B Thus, the total cash flow to all stakeholders is ( EBIT rB B ) rB B The present value of this stream of cash flows is VL Clearly ( EBIT rB B ) rB B EBIT The present value of this stream of cash flows is VU VL VU McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc All Rights 15 The MM Proposition II (No Taxes) The derivation is straightforward: rWACC B S rB rS B S B S B S rB rS r0 B S B S Then set rWACC r0 B S multiply both sides by S B S B B S S B S rB rS r0 S B S S B S S B B S rB rS r0 S S B B rB rS r0 r0 S S McGraw-Hill/Irwin Corporate Finance, 7/e B rS r0 (r0 rB ) S © 2005 The McGraw-Hill Companies, Inc All Rights 16 Cost of capital: r (%) The Cost of Equity, the Cost of Debt, and the Weighted Average Cost of Capital: MM Proposition II with No Corporate Taxes r0 rS r0 rWACC B (r0 rB ) SL B S rB rS BS BS rB rB B Debt-to-equity Ratio S McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc All Rights 17 The MM Propositions I & II (with Corporate 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 interest tax shield r S = r + (B/S)×(1-T C)×(r - r B) 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 levered equity McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc All Rights 18 The MM Proposition I (Corp Taxes) Shareholders in a levered firm receive Bondholders receive ( EBIT rB B ) (1 TC ) rB B Thus, the total cash flow to all stakeholders 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 EBIT (1 TC ) rB B (1 TC ) rB B EBIT (1 TC ) rB B rB BTC rB B The present value of the first term is VU The present value of the second term is TCB McGraw-Hill/Irwin Corporate Finance, 7/e VL VU TC B © 2005 The McGraw-Hill Companies, Inc All Rights 19 The MM Proposition II (Corp Taxes) Start with M&M Proposition I with taxes: Since VL S B VL VU TC B S B VU TC B VU S B(1 TC ) The cash flows from each side of the balance sheet must equal: SrS BrB VU r0 TC BrB SrS BrB [ S B(1 TC )]r0 TC rB B Divide both sides by S B B B rS rB [1 (1 TC )]r0 TC rB S S S B rS r0 (1 TC ) (r0 rB ) Which quickly reduces to S McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc All Rights 20 The Effect of Financial Leverage on the Cost of Debt and Equity Capital with Corporate Taxes Cost of capital: r (%) rS r0 rS r0 B (r0 rB ) SL B (1 TC ) (r0 rB ) SL r0 rWACC B SL rB (1 TC ) rS BS L B SL rB Debt-to-equity ratio (B/S) McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc All Rights 21 Total Cash Flow to Investors Under Each Capital Structure with Corp Taxes All-Equity EBIT Interest EBT Taxes (Tc = 35% Total Cash Flow to S/H Recession $1,000 $1,000 $350 Expected $2,000 $2,000 $700 Expansion $3,000 $3,000 $1,050 $650 $1,300 $1,950 LeveredRecession EBIT Interest ($800 @ 8% ) EBT Taxes (Tc = 35%) Total Cash Flow (to both S/H & B/H): EBIT(1-Tc)+TCCrBBB McGraw-Hill/Irwin Corporate Finance, 7/e ExpectedExpansion $1,000$2,000 $3,000 640640 640 $360$1,360 $2,360 $126$476 $826 $234+640$468+$640$1,534+$640 $874$1,524 $2,174 $650+$224$1,300+$224$1,950+$224 $874$1,524 $2,174 © 2005 The McGraw-Hill Companies, Inc All Rights 22 Total Cash Flow to Investors Under Each Capital Structure with Corp Taxes All-equity firm S G Levered firm S G B 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 McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc All Rights 23 Total Cash Flow to Investors Under Each Capital Structure with Corp Taxes All-equity firm S G Levered firm S G B 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! McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc All Rights 24 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 Prop 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 rS r0 McGraw-Hill/Irwin Corporate Finance, 7/e B ( r0 rB ) SL © 2005 The McGraw-Hill Companies, Inc All Rights 25 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 Prop 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 rS r0 McGraw-Hill/Irwin Corporate Finance, 7/e B (1 TC ) ( r0 rB ) SL © 2005 The McGraw-Hill Companies, Inc All Rights 26 Prospectus: Bankruptcy Costs So far, we have seen M&M suggest that financial leverage does not matter, or imply that taxes cause the optimal financial structure to be 100% debt In the real world, most executives 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 The important use of this chapter is to get comfortable with “M&M algebra” McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc All Rights ... Capital: MM Proposition II with No Corporate Taxes r0 rS r0 rWACC B (r0 rB ) SL B S rB rS BS BS rB rB B Debt-to-equity Ratio S McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill... The MM Propositions I & II (with Corporate Taxes) Proposition I (with Corporate Taxes) Firm value increases with leverage VL = VU + TC B Proposition II (with Corporate Taxes) Some of the increase... S McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc All Rights 20 The Effect of Financial Leverage on the Cost of Debt and Equity Capital with Corporate Taxes Cost