McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc. All Rights Reserved CHAPTER 15 Capital Structure: Basic Concepts

McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc. All Rights Reserved 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 15.1 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 Reserved 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 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 SBSB SBSB

McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc. All Rights Reserved 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. 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.

McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc. All Rights Reserved Financial Leverage, EPS, and ROE Current Assets$20,000 Debt$0 Equity$20,000 Debt/Equity ratio0.00 Interest raten/a Shares outstanding400 Share price$50 Current Assets$20,000 Debt$0 Equity$20,000 Debt/Equity ratio0.00 Interest raten/a Shares outstanding400 Share price$50 Proposed $20,000 $8,000 $12,000 2/3 8% 240 $50 Consider an all-equity firm that is considering going into debt. (Maybe some of the original shareholders want to cash out.)

McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc. All Rights Reserved EPS and ROE Under Current Capital Structure RecessionExpectedExpansion EBIT$1,000$2,000$3,000 Interest000 Net income$1,000$2,000$3,000 EPS$2.50$5.00$7.50 ROA5%10%15% ROE5%10%15% Current Shares Outstanding = 400 shares RecessionExpectedExpansion EBIT$1,000$2,000$3,000 Interest000 Net income$1,000$2,000$3,000 EPS$2.50$5.00$7.50 ROA5%10%15% ROE5%10%15% Current Shares Outstanding = 400 shares

McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc. All Rights Reserved EPS and ROE Under Proposed Capital Structure RecessionExpectedExpansion EBIT$1,000$2,000$3,000 Interest Net income$360$1,360$2,360 EPS$1.50$5.67$9.83 ROA5%10%15% ROE3%11%20% Proposed Shares Outstanding = 240 shares RecessionExpectedExpansion EBIT$1,000$2,000$3,000 Interest Net income$360$1,360$2,360 EPS$1.50$5.67$9.83 ROA5%10%15% ROE3%11%20% Proposed Shares Outstanding = 240 shares

McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc. All Rights Reserved EPS and ROE Under Both Capital Structures Levered RecessionExpectedExpansion EBIT$1,000$2,000$3,000 Interest Net income$360$1,360$2,360 EPS$1.50$5.67$9.83 ROA5%10%15% ROE3%11%20% Proposed Shares Outstanding = 240 shares Levered RecessionExpectedExpansion EBIT$1,000$2,000$3,000 Interest Net income$360$1,360$2,360 EPS$1.50$5.67$9.83 ROA5%10%15% ROE3%11%20% Proposed Shares Outstanding = 240 shares All-Equity RecessionExpectedExpansion EBIT$1,000$2,000$3,000 Interest000 Net income$1,000$2,000$3,000 EPS$2.50$5.00$7.50 ROA5%10%15% ROE5%10%15% Current Shares Outstanding = 400 shares

McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc. All Rights Reserved Financial Leverage and EPS (2.00) ,0002,0003,000 EPS Debt No Debt Break-even point EBIT in dollars, no taxes Advantage to debt Disadvantage to debt

McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc. All Rights Reserved 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 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 Reserved Homemade Leverage: An Example RecessionExpectedExpansion EPS of Unlevered Firm$2.50$5.00$7.50 Earnings for 40 shares$100$200$300 Less interest on $800 (8%)$64$64$64 Net Profits$36$136$236 ROE (Net Profits / $1,200)3%11%20% We are buying 40 shares of a $50 stock on margin. We get the same ROE as if we bought into a levered firm. Our personal debt equity ratio is: ,1$ 800$  S B

McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc. All Rights Reserved 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 sum of the firm’s debt gets us to the ROE of the unlevered firm. This is the fundamental insight of M&M 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 sum 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 Reserved The MM Propositions I & II (No Taxes) Proposition I Firm value is not affected by leverage V L = V U Proposition II Leverage increases the risk and return to stockholders r s = r 0 + (B / S L ) (r 0 - r B ) r B is the interest rate (cost of debt) r s is the return on (levered) equity (cost of equity) r 0 is the return on unlevered equity (cost of capital) B is the value of debt S L is the value of levered equity Proposition I Firm value is not affected by leverage V L = V U Proposition II Leverage increases the risk and return to stockholders r s = r 0 + (B / S L ) (r 0 - r B ) r B is the interest rate (cost of debt) r s is the return on (levered) equity (cost of equity) r 0 is the return on unlevered equity (cost of capital) B is the value of debt S L is the value of levered equity

McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc. All Rights Reserved The MM Proposition I (No Taxes) UL VV  BrEBIT B  receive firm levered ain rsShareholde Br B receive sBondholder The derivation is straightforward: BrBrEBIT BB  )( is rsstakeholde all toflowcash total theThus, The present value of this stream of cash flows is V L EBITBrBr BB  )( Clearly The present value of this stream of cash flows is V U

McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc. All Rights Reserved The MM Proposition II (No Taxes) The derivation is straightforward: SBWACC r SB S r SB B r      0 setThenrr WACC  0 rr SB S r SB B SB     S SB  by sidesbothmultiply 0 r S SB r SB S S SB r SB B S SB SB          0 r S SB rr S B SB   00 rr S B rr S B SB  )( 00 BS rr S B rr 

McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc. All Rights Reserved 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 Cost of capital: r (%) r0r0 rBrB rBrB S B

McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc. All Rights Reserved The MM Propositions I & II (with Corporate Taxes) Proposition I (with Corporate Taxes) Firm value increases with leverage V L = V U + T C B Proposition II (with Corporate Taxes) Some of the increase in equity risk and return is offset by interest tax shield r S = r 0 + (B/S)×(1-T C )×(r 0 - r B ) r B is the interest rate (cost of debt) r S is the return on equity (cost of equity) r 0 is the return on unlevered equity (cost of capital) B is the value of debt S is the value of levered equity Proposition I (with Corporate Taxes) Firm value increases with leverage V L = V U + T C B Proposition II (with Corporate Taxes) Some of the increase in equity risk and return is offset by interest tax shield r S = r 0 + (B/S)×(1-T C )×(r 0 - r B ) r B is the interest rate (cost of debt) r S is the return on equity (cost of equity) r 0 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 Reserved The MM Proposition I (Corp. Taxes) BTVV CUL  )1()( receive firm levered ain rsShareholde CB TBrEBIT  Br B receive sBondholder BrTBrEBIT BCB  )1()( is rsstakeholde all toflowcash total theThus, The present value of this stream of cash flows is V L  BrTBrEBIT BCB )1()(Clearly The present value of the first term is V U The present value of the second term is T C B BrTBrTEBIT BCBC  )1()1(BrBTrBrTEBIT BCBBC  )1(

McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc. All Rights Reserved The MM Proposition II (Corp. Taxes) Start with M&M Proposition I with taxes: )()1( 00 BCS rrT S B rr  BTVV CUL  Since BSV L  The cash flows from each side of the balance sheet must equal: BCUBS BrTrV Sr  0 BrTrTBSBrSr BCCBS  0 )]1([ Divide both sides by S BCCBS rT S B rT S B r S B r  0 )]1(1[ BTVBS CU  )1( CU TBSV  Which quickly reduces to

McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc. All Rights Reserved The Effect of Financial Leverage on the Cost of Debt and Equity Capital with Corporate Taxes Debt-to-equity ratio (B/S) Cost of capital: r (%) r0r0 rBrB

McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc. All Rights Reserved Total Cash Flow to Investors Under Each Capital Structure with Corp. Taxes All-Equity RecessionExpectedExpansion EBIT$1,000$2,000$3,000 Interest000 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 Levered RecessionExpectedExpansion EBIT$1,000$2,000$3,000 Interest 8% ) EBT$360$1,360$2,360 Taxes (Tc = 35%)$126$476$826 Total Cash Flow $ $468+$640$1,534+$640 (to both S/H & B/H): $874$1,524$2,174 EBIT(1-Tc)+T C r B B $650+$224$1,300+$224$1,950+$224 $874$1,524$2,174 Levered RecessionExpectedExpansion EBIT$1,000$2,000$3,000 Interest 8% ) EBT$360$1,360$2,360 Taxes (Tc = 35%)$126$476$826 Total Cash Flow $ $468+$640$1,534+$640 (to both S/H & B/H): $874$1,524$2,174 EBIT(1-Tc)+T C r B B $650+$224$1,300+$224$1,950+$224 $874$1,524$2,174

McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc. All Rights Reserved Total Cash Flow to Investors Under Each 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. SGSG B All-equity firm Levered firm

McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc. All Rights Reserved Total Cash Flow to Investors Under Each Capital Structure with Corp. Taxes 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! SGSG B All-equity firm Levered firm

McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc. All Rights Reserved 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: V L = V U 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 In a world of no taxes, the value of the firm is unaffected by capital structure. This is M&M Proposition I: V L = V U 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 )( 00B L S rr S B rr 

McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc. All Rights Reserved 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: V L = V U + T C 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. In a world of taxes, but no bankruptcy costs, the value of the firm increases with leverage. This is M&M Proposition I: V L = V U + T C 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. )()1( 00BC L S rrT S B rr 

McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc. All Rights Reserved 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 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. The important use of this chapter is to get comfortable with “M&M algebra”. 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 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. The important use of this chapter is to get comfortable with “M&M algebra”.