J. K. Dietrich - GSBA 548 – MBA.PM Spring 2007 Capital Structure April 30, 2007 (LA) and April 26, 2007 (OCC)

J. K. Dietrich - GSBA 548 – MBA.PM Spring 2007 u An unlevered company is an all equity firm u A levered company has debt and equity in its capital structure u The capital structure debate concerns the impact on total firm value of companies having identical assets but different capital structures, i.e. levered versus unlevered u If debt in capital structure adds value, it adds to shareholders’ value Capital Structure Debate

J. K. Dietrich - GSBA 548 – MBA.PM Spring 2007 Summary M-M Debate Issues

J. K. Dietrich - GSBA 548 – MBA.PM Spring 2007 Debate and Basic Concepts u Portfolios –Investors hold portfolios –Portfolios may contain bonds, stocks, and be leveraged with debt u Efficient markets –Informed investors, transactions costs low u Arbitrage –Strong economic force operating at all times –Search for profits from “buy cheap, sell dear”

J. K. Dietrich - GSBA 548 – MBA.PM Spring 2007 Returns to Debt and Equity u Each claimant on the income of the firm has expected returns based on the degree of risk associated with the income from the claims u Management of firms must satisfy expectations of providers of capital to maintain value of firm u If higher returns are earned, shareholders gain

J. K. Dietrich - GSBA 548 – MBA.PM Spring 2007 Distribution of Corporate Income EAC (Div + Retained Earnings) I (Fixed Claims) T (No Value to Investors) E B I T

J. K. Dietrich - GSBA 548 – MBA.PM Spring 2007 Capital Structure u Modigliani and Miller (1958, 1963) u “Pie Model of Firm Value” (pp. 2ff, 423ff) V = B + S u Unlevered versus levered firm u Weighted average cost of capital (no taxes)

J. K. Dietrich - GSBA 548 – MBA.PM Spring 2007 Propositions I and II u Assumptions –No taxes –Markets efficient –No bankruptcy or reorganization costs –Homemade leverage possible –Example problems u Economic forces simple and powerful u What are investors willing to pay for?

J. K. Dietrich - GSBA 548 – MBA.PM Spring 2007 Investor Returns from EBIT u Absence of taxes in M-M Propositions u EBIT = operating income paid to shareholders and bondholders u Homemade leverage possible at same terms as firm’s cost of debt u Unmaking leverage possible by buying debt u What can firms do for investors they can’t do for themselves in efficient markets?

J. K. Dietrich - GSBA 548 – MBA.PM Spring 2007 Capital Structure Irrelevant u Proposition I (pp ) (Value of firm not influenced by B and S) u Proposition II (p. 432, equation 15.3) (Overall discount rate not influenced by B and S)

J. K. Dietrich - GSBA 548 – MBA.PM Spring 2007 M-M Proposition I and II Graphs rBrB Cost of Funds D/E Firm Value r WACC rSrS VoVo 00

J. K. Dietrich - GSBA 548 – MBA.PM Spring 2007 Issues in M-M Analysis u Taxes reduce cost of debt u Bankruptcy costs from failure to make scheduled debt payments –Attorneys –Lost sales, production –Costs of reorganization, acquisition u Agency costs of debt –Incentives of bond and stockholders –Costs of monitoring

J. K. Dietrich - GSBA 548 – MBA.PM Spring 2007 Value of Claims on Firm: Taxes u Unlevered firm’s value (p. 442): u Levered firm’s value (p. 442, equation 15.5):

J. K. Dietrich - GSBA 548 – MBA.PM Spring 2007 The Capital Structure Debate rBrB Cost of Funds D/E Firm Value rSrS r WACC VoVo 0 0

J. K. Dietrich - GSBA 548 – MBA.PM Spring 2007 Capital Structure & Equilibrium u In equilibrium, both firms and investors expected after-tax returns on debt and equity must be consistent with each other u Value of firm will be influenced by corporate and personal tax rates (see p. 478):

J. K. Dietrich - GSBA 548 – MBA.PM Spring 2007 State of Capital Structure Debate u Market equilibrium pricing reduces value of debt financing (“Debt and Taxes” argument of Miller) u Some debt financing seems reasonable u Over some range precise D/E value not clear and there are adjustment costs –Pecking order theory of financing (p. 472) –Investment banking fees –Costs of going to market

J. K. Dietrich - GSBA 548 – MBA.PM Spring 2007 Debt and Equity as Financial Claims on a Firm’s Assets F = Face Value of Debt Value of Claim 0 Debt Claims Equity Claim Value of Assets

J. K. Dietrich - GSBA 548 – MBA.PM Spring 2007 Debt as a Fixed Claim F = Face Value of Debt 0 Debt Claims Value of Assets Value of Claim

J. K. Dietrich - GSBA 548 – MBA.PM Spring 2007 Equity, a Residual Claim Equity Claim F = Face Value of Debt 0 Value of Assets Value of Claim

J. K. Dietrich - GSBA 548 – MBA.PM Spring 2007 Debt and Equity as Contingent Claims F = Face Value of Debt 0 Equity Claim Probability Scale Debt Claims Value of Claim

J. K. Dietrich - GSBA 548 – MBA.PM Spring 2007 Last Classes u Prepare Chapter 18 problems u Submit Part 4 (group part only) and organize group time to incorporate feedback and complete project summary u Review course materials and midterm performance to identify topics where you need clarification or assistance