© 2012 McGraw-Hill Ryerson LimitedChapter The value of a firm from two angles AssetsLiabilities and Stockholder’s Equity Value of cash flows from firm’s real assets and operations Market value of debt Market value of equity Value of Firm LO1

© 2012 McGraw-Hill Ryerson LimitedChapter  A firm’s capital structure is the mix of debt and equity its financial managers choose  Does the choice of capital structure affect the value of a firm  Modigliani and Miller (MM) ◦ When there are no taxes and well functioning capital markets exist, the market value of a company does not depend on its capital structure ◦ In other words, managers cannot increase firm value by changing the mix of securities used to finance the company LO1

© 2012 McGraw-Hill Ryerson LimitedChapter  MM Assumptions: ◦ Capital markets have to be “well functioning”  Investors can borrow/lend on the same terms as firms  Capital markets are efficient ◦ There are no taxes or costs of financial distress  Example: in the next few slides, it is shown how the River Cruise company is operating now and how can it change its structure. At the end, it is shown that whatever it achieves by changing its structure, can be replicated by the shareholders themselves. MM called it the ‘home-made leverage’. LO1

© 2012 McGraw-Hill Ryerson LimitedChapter The River Cruise example: Current Structure 1 of million $SharesofValueMarket $10shareperPrice 100,000sharesNumber Value of firm = $1 mill 17.5%12.5%7.5% Return on Shares $.75shareperEarnings 175,000125,000$75,000IncomeOperating BoomExpectedSlump Economy the State ofOutcome LO1

© 2012 McGraw-Hill Ryerson LimitedChapter  The River Cruise example: Proposed Structure Issue $500,000 of debt with a 10% coupon and use the funds to repurchase 50,000 shares at $10 apiece 500,000debtofueMarket val 500,000SharesofValueMarket $10 shareperPrice 50,000sharesofNumber Value of firm = D+E= $500,000 + $500,000 = $1 mill LO1

© 2012 McGraw-Hill Ryerson LimitedChapter Earnings and returns per share with debt 25%15%5% Return on shares $.50shareperEarnings 125,00075,000$25,000earningsEquity 50,000 $50,000Interest 175,000125,000$75,000IncomeOperating BoomExpectedSlump State of the Economy LO1

© 2012 McGraw-Hill Ryerson LimitedChapter If the firm did not borrow, but the shareholders borrowed $10 to buy one more share. This would make them have a debt of 50%, the same as that of the proposed firm structure. LO1

© 2012 McGraw-Hill Ryerson LimitedChapter How borrowing affects risk and return Firm Value: All Equity FinancingAfter Restructuring $1 million Debt: Equity: $500,000 LO1 Even though the value of the firm remains unchanged, shareholders of the levered firm face a higher risk and therefore demand a higher return

© 2012 McGraw-Hill Ryerson LimitedChapter  Restructuring does not affect operating income ◦ The operating risk, or business risk, of the firm is unchanged ◦ However, with more debt in the capital structure, the EPS becomes more risky. The financial risk of the firm increases.  MM’s Proposition II ◦ The required return on a firm’s equity increases as the firm’s debt-equity ratio increases LO1

© 2012 McGraw-Hill Ryerson LimitedChapter MM’s proposition II with constant r Debt Note: r debt need not be constant LO1