GROUP MEMBER HENRY EBUN ASMARAH RIKUN NOORINA ABD HAMID BUDIRMAN DAUD

Capital Structure: Basic Concepts Chapter 15

Chapter outline 15.1The capital structure question and the pie theory. 15.2Maximizing Firm value Vs Maximizing Stockholder Interests. 15.3Financial Leverage and Firm Value: An Example. 15.4Modigliani and Miler:Proposition II (No Taxes). 15.5Taxes. Question And Answer

15.1 The Capital Structure Question and The Pie Theory Definition: Capital Structure is the mix of financial securities used to finance the firm. 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, then the firm should pick the debt-equity ratio that makes the pie as big as possible. S B S Value of the Firm S

15.2 M&M No Tax: Result A change in capital structure does not matter to the overall value of the firm. Total Firm Value = S+B Does not change (the pie is the same size in each case, just the slices are different). Equity, $1000, 100% Equity, $700, 70%, Debt $300, 30%, Equity, $400, 40%, Debt $600, 60%,

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. Note: When we talk about a change in capital structure, we usually hold other things constant. Thus, an increase in debt financing implies that equity will be repurchased (and vice versa) so that overall assets remain unchanged.

The Objective of Management Since management is (in principle) controlled by the shareholders, we normally assume that management seeks to maximize the value of the firm’s equity. However, as long as there are no costs of bankruptcy, maximizing equity value S is equivalent to maximizing firm value V. Example: A firm has 10,000 shares; share price is $25 debt has a market value of $100,000 firm value V = B +S = $100,000+$25×$10,000 = $350,000 suppose the firm borrows another $50,000 and pays it immediately as a special dividend the value of debt increases to $150,000, but how are shareholders affected?

The Objective of Management Cont’d Consider three possible outcomes: V ↑ $380,000V → $350,000 V ↓ $320,000 S $230,000 $200,000 $170,000 Dividend $50,000 $50,000 $50,000 Capital gain/loss -$20,000 -$50,000 -$80,000 Net gain/loss $30,000 $0 -$30,000 The change in capital structure benefits the shareholders if and only if the value of the firm increases Managers should choose the capital structure that they believe will have the highest firm value (i.e. make the pie as big as possible)

15.3 Financial Leverage and Firm Value Current Assets$8000$8000 Debt$0$4000 Equity$8000$4000 Interest rate 10%10% Market value/share$20$20 Shares outstanding Proposed Consider an all-equity firm that is contemplating going into debt. (Maybe some of the original shareholders want to cash out.)

Current Capital Structure: No Debt RecessionExpectedExpansion ROA5%15%25% Earnings$400$1,200$2,000 ROE5%15%25% EPS$1$3$5

Proposed Capital Structure: Debt Debt = $4,000 RecessionExpected Expansion ROA5%15%25% EBI$400$1,200$2,000 Interest EAI$0$800$1,600 ROE020%40% EPS0$4$8

Financial Leverage and EPS $400$800$1,600 EPS ($) Debt No Debt Break-even point EBI in dollars, no taxes Advantage to debt Disadvantage to debt $1,200 $2,000

The Choice Between Debt and Equity Strategy A: Buy 100 Shares of Levered Equity RecessionExpected Expansion EPS$0$4$8 Earnings Initial cost = 100 MM Proposition I (No Taxes)

Strategy B: Homemade Leverage RecessionExpected Expansion EPS ,000 Interest Net earnings $0 $400 $800 Initial cost = 200 $2,000 = $2,000

15.4 MM PROPOSITION II (NO TAXES) Proposition II Leverage increases the risk and return to stockholders R S = R O + (B/S L ) (R O -R B ) R B is the interest rate (cost of debt) R S is the return on (levered) equity (cost of equity) R O is the return on unlevered equity (cost of capital) B is the value of debt S L is the value of levered equity A higher debt-to- equity ratio leads to a higher required return on equity, because of the higher risk involved for equity-holders in a company with debt. The formula is derived from the theory of Weighted Average Cost of Capital (WACC)

The derivation is straightforward: R WACC = S/B + S x R S + B/B + S x R B Where R B is the cost of debt R S is the expected return on equity or stock, also called the cost of equity or the required return on equity R WACC is the firm ’ s weighted average cost of capital is the firm ’ s weighted average cost of capital Bis the value of the firm ’ s debt or bonds Sis the value of the firm ’ s stock or equity A firm ’ s weighted average cost of capital is a weighted average of its cost of debt and its cost of equity. The weight applied to debt is proportion of the debt in the capital structure, and the weight applied to equity is the proportion of equity in the capital structure.  Note : R WACC means an average representing the expected return on all of a company ’ s securities, each source of capital, such as stocks bonds and other debt is weighted in the calculation according to its prominence in the company ’ s capital structure

GRAPH Cost of capital : R (%) R0R0 R S R WAC R B Debt – equity ratio (B/S)

R S =R O + (R O – R B ) B/S R S is the cost of equity R B is the cost of debt R O is the cost of capital for an all-equity firm R WACC is a firm ’ s weighted average cost of capital. In a is a firm ’ s weighted average cost of capital. In a world with no taxes, R WACC for a levered firm is equal to R O R O is a single point whereas R S, R B and R WACC are all entire lines

Summary of MM Propositions without taxes 1.Assumptions  -No taxes  -No transaction costs  -Individuals and corporations borrow at same rate 2.Results  Proposition I = V L = V U (Value of levered firm equals value of unlevered firm)  Proposition II = R S = R O = B / S (R O –R B ) 3. Intuition  Proposition I :Through homemade leverage individuals can either duplicate or undo the effects of corporate leverage  Proposition II : The cost of equity rises with leverage because the risk to equity rises with leverage

1.Tax definition : Tax is to impose a financial charge or other levy upon a taxpayer by a state or the functional equivalent of a state. 2. The value of the levered firm is the sum of the value of the debt and the value of the equity. 3. The firm value is positively related to debt within tax. 4. MM Proposition I (with corporate taxes) - Firm value increases with leverage : V L = V u + T c B  V L is the value of a levered firm  V U is the value of an un levered firm  T C B is the present value of tax shield is the tax rate (T C ) x the value of debt (B)

5. MM Proposition II (with corporate taxes) - Some of the increase in equity risk and return is offset by the interest tax shield. MM Proposition II states that leverage increase the risk and return to stockholders: R s = R o + (B/S L ) x (1-T c ) x (R o – R B ) R S is the required rate of return on equity, or cost of equity. R o is the cost of capital for an all equity firm. R B is the required rate of return on borrowings, or cost of debt. B/S L is the debt-to-equity ratio. T c is the tax rate.

Example: The Water Products Company Earnings before interest and taxes (EBIT) = $1,000,000 Corporate Tax rate (tc) = 35% Debt (B) = $4,000,000 Cost of debt (R B ) = 10% Interest (R B B) = $400,000 (.10 x $4,000,000) Plan 1 (Unlevered) Plan 2 (Levered) Earnings before interest and corporate taxes (EBIT) 1,000,000 Interest (R B B)0400,000 Earnings before taxes (EBT)1,000,000600,000 Taxes (Tc =.35)350,000210,000 Earning after corporate taxes650,000390,000 Total cash flow (Stockholder + bondholder) 650,000790,000 The levered firm pays less in taxes than does the unlevered firm about $140K ($350-$210). Thus the sum of the debt plus the equity ($400K + $390K) of the levered firm is greater than the equity of the unlevered firm ($650K). MM PROPOSITION I (WITH TAXES)

Debt $400K + Equity $390K = Firm Value $790K Firm Value $650K Tax Shield= Tc X R B x B =.35 x.1 x $4,000,000 = $140K The value of an unlevered firm (no debt) is the present value of EBIT x (1-tc) = V u $1,000,000 x (1-.35) = $650,000 Levered increases the value of the firm by the tax shield. V L = V u + tcB = $650,000 + $140,000 = $790,000

Value of the Levered Firm VLVL Firm Value Debt B VLVL Value of the firm levered is related to debt. The value firm will increase when debt is increase. VUVU B1 VL1VL1

MM PROPOSITION II ( WITH TAXES) Expected Return and Leverage under Corporate Taxes 1.Expected return on equity and leverage is positive relationship. 2.The expected on equity increase with leverage. 3.The expected on earning per share increase with leverage. 4.The risk of equity increase with Leverage. The Weighted Average Cost of Capital, RWACC, and corporate Taxes 1.In the no-tax case, RWACC is not affected by leverage. 2.But, RWACC will decline with leverage in a world with corporate taxes. Stock Price and Leverage under Corporate Taxes 1. The price of the stock increase with levered firm.

R0R0 RBRB Cost of capital: R (%) Debt-to-equity ratio (B/S) The Effect of Financial Leverage

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