1. Prepared by Professor Wei Wang Queen’s University © 2011 McGraw–Hill Ryerson Limited Capital Structure: Basic Concepts Chapter Sixteen

2. 2-1 © 2011 McGraw–Hill Ryerson Limited 15-1 © 2011 McGraw–Hill Ryerson Limited 16-1 © 2011 McGraw–Hill Ryerson Limited Chapter Outline 16.1 The Capital-Structure Question and The Pie Theory 16.2 Maximizing Firm Value versus Maximizing Stockholder Interests 16.3 Financial Leverage and Firm Value: An Example 16.4 Modigliani and Miller: Proposition II (No Taxes) 16.5 Taxes 16.6 Summary and Conclusions

3. 2-2 © 2011 McGraw–Hill Ryerson Limited 15-2 © 2011 McGraw–Hill Ryerson Limited 16-2 © 2011 McGraw–Hill Ryerson Limited The Capital-Structure Question and The Pie Theory LO16.1 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. Value of the Firm SBB SBSB

4. 2-3 © 2011 McGraw–Hill Ryerson Limited 15-3 © 2011 McGraw–Hill Ryerson Limited 16-3 © 2011 McGraw–Hill Ryerson Limited The Capital-Structure Question LO16.1 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.

5. 2-4 © 2011 McGraw–Hill Ryerson Limited 15-4 © 2011 McGraw–Hill Ryerson Limited 16-4 © 2011 McGraw–Hill Ryerson Limited Maximizing Firm Value versus Maximizing Stockholder Interests LO16.2 The text demonstrates through an example that shareholders should care about maximizing firm value rather than in strategies that maximize equity value. In general, changes in capital structure benefit (hurt) shareholders if and only if firm value increases (decreases) Therefore, managers should choose the capital structure that maximizes the firm value.

6. 2-5 © 2011 McGraw–Hill Ryerson Limited 15-5 © 2011 McGraw–Hill Ryerson Limited 16-5 © 2011 McGraw–Hill Ryerson Limited Financial Leverage, EPS, and ROE LO16.3 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.)

7. 2-6 © 2011 McGraw–Hill Ryerson Limited 15-6 © 2011 McGraw–Hill Ryerson Limited 16-6 © 2011 McGraw–Hill Ryerson Limited EPS and ROE Under Current Capital Structure LO16.3 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

8. 2-7 © 2011 McGraw–Hill Ryerson Limited 15-7 © 2011 McGraw–Hill Ryerson Limited 16-7 © 2011 McGraw–Hill Ryerson Limited EPS and ROE Under Current Capital Structure LO16.3 RecessionExpectedExpansion EBIT$1,000$2,000$3,000 Interest640640640 Net income$360$1,360$2,360 EPS$1.50$5.67$9.83 ROA1.8%6.8%11.8% ROE3.0%11.3%19.7% Proposed Shares Outstanding = 240 shares

9. 2-8 © 2011 McGraw–Hill Ryerson Limited 15-8 © 2011 McGraw–Hill Ryerson Limited 16-8 © 2011 McGraw–Hill Ryerson Limited EPS and ROE Under Both Capital Structures LO16.3 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 Levered RecessionExpectedExpansion EBIT$1,000$2,000$3,000 Interest640640640 Net income$360$1,360$2,360 EPS$1.50$5.67$9.83 ROA1.8%6.8%11.8% ROE3.0%11.3%19.7% Proposed Shares Outstanding = 240 shares

10. 2-9 © 2011 McGraw–Hill Ryerson Limited 15-9 © 2011 McGraw–Hill Ryerson Limited 16-9 © 2011 McGraw–Hill Ryerson Limited Financial Leverage and EPS LO16.3 (2.00) 0.00 2.00 4.00 6.00 8.00 10.00 12.00 1,0002,0003,000 EPS Debt No Debt Break-even point EBI in dollars, no taxes Advantage to debt Disadvantage to debt EBIT

11. 2-10 © 2011 McGraw–Hill Ryerson Limited 15-10 © 2011 McGraw–Hill Ryerson Limited 16-10 © 2011 McGraw–Hill Ryerson Limited Assumptions of the Modigliani-Miller Model LO16.3 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

12. 2-11 © 2011 McGraw–Hill Ryerson Limited 15-11 © 2011 McGraw–Hill Ryerson Limited 16-11 © 2011 McGraw–Hill Ryerson Limited Homemade Leverage: An Example LO16.3 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 / $12,000)3.0%11.3%19.7% 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:

13. 2-12 © 2011 McGraw–Hill Ryerson Limited 15-12 © 2011 McGraw–Hill Ryerson Limited 16-12 © 2011 McGraw–Hill Ryerson Limited Homemade (Un)Leverage: An Example LO16.3 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

14. 2-13 © 2011 McGraw–Hill Ryerson Limited 15-13 © 2011 McGraw–Hill Ryerson Limited 16-13 © 2011 McGraw–Hill Ryerson Limited MM Proposition I (No Taxes) LO16.3 We can create a levered or unlevered position by adjusting the trading in our own account. This homemade leverage suggests that capital structure is irrelevant in determining the value of the firm. Proposition I –Firm value is not affected by leverage V L = V U

15. 2-14 © 2011 McGraw–Hill Ryerson Limited 15-14 © 2011 McGraw–Hill Ryerson Limited 16-14 © 2011 McGraw–Hill Ryerson Limited Proving MM Proposition I (No Taxes) LO16.3 The derivation is straightforward: The present value of this stream of cash flows is V L The present value of this stream of cash flows is V U

16. 2-15 © 2011 McGraw–Hill Ryerson Limited 15-15 © 2011 McGraw–Hill Ryerson Limited 16-15 © 2011 McGraw–Hill Ryerson Limited 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 MM Proposition II (No Taxes) LO16.4

17. 2-16 © 2011 McGraw–Hill Ryerson Limited 15-16 © 2011 McGraw–Hill Ryerson Limited 16-16 © 2011 McGraw–Hill Ryerson Limited MM Proposition II (No Taxes) LO16.4 The derivation is straightforward:

18. 2-17 © 2011 McGraw–Hill Ryerson Limited 15-17 © 2011 McGraw–Hill Ryerson Limited 16-17 © 2011 McGraw–Hill Ryerson Limited The Cost of Equity, the Cost of Debt, and the Weighted Average Cost of Capital: MM Proposition II with No Corporate Taxes LO16.4 Debt-to-equity Ratio Cost of capital: r (%) r0r0 rBrB rBrB

19. 2-18 © 2011 McGraw–Hill Ryerson Limited 15-18 © 2011 McGraw–Hill Ryerson Limited 16-18 © 2011 McGraw–Hill Ryerson Limited Taxes: The MM Propositions I & II (with Corporate Taxes) LO16.5 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

20. 2-19 © 2011 McGraw–Hill Ryerson Limited 15-19 © 2011 McGraw–Hill Ryerson Limited 16-19 © 2011 McGraw–Hill Ryerson Limited The MM Proposition I (Corp. Taxes) LO16.5 The present value of this stream of cash flows is V L The present value of the first term is V U The present value of the second term is T C B

21. 2-20 © 2011 McGraw–Hill Ryerson Limited 15-20 © 2011 McGraw–Hill Ryerson Limited 16-20 © 2011 McGraw–Hill Ryerson Limited The MM Proposition II (Corp. Taxes) LO16.5 Start with M&M Proposition I with taxes: Since The cash flows from each side of the balance sheet must equal: Divide both sides by S Which quickly reduces to

22. 2-21 © 2011 McGraw–Hill Ryerson Limited 15-21 © 2011 McGraw–Hill Ryerson Limited 16-21 © 2011 McGraw–Hill Ryerson Limited The Effect of Financial Leverage on the Cost of Debt and Equity Capital with Corporate Taxes LO16.5 Debt-to-equity ratio (B/S) Cost of capital: r (%) r0r0 rBrB

23. 2-22 © 2011 McGraw–Hill Ryerson Limited 15-22 © 2011 McGraw–Hill Ryerson Limited 16-22 © 2011 McGraw–Hill Ryerson Limited Total Cash Flow to Investors Under Each Capital Structure with Corp. Taxes LO16.5 Levered RecessionExpectedExpansion EBIT$1,000$2,000$3,000 Interest ($800 @ 8% )640640640 EBT$360$1,360$2,360 Taxes (Tc = 35%)$126$476$826 Total Cash Flow $234+640$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 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

24. 2-23 © 2011 McGraw–Hill Ryerson Limited 15-23 © 2011 McGraw–Hill Ryerson Limited 16-23 © 2011 McGraw–Hill Ryerson Limited Total Cash Flow to Investors Under Each Capital Structure with Corp. Taxes LO16.5 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

25. 2-24 © 2011 McGraw–Hill Ryerson Limited 15-24 © 2011 McGraw–Hill Ryerson Limited 16-24 © 2011 McGraw–Hill Ryerson Limited Total Cash Flow to Investors Under Each Capital Structure with Corp. Taxes LO16.5 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

26. 2-25 © 2011 McGraw–Hill Ryerson Limited 15-25 © 2011 McGraw–Hill Ryerson Limited 16-25 © 2011 McGraw–Hill Ryerson Limited Summary: Taxes LO16.6 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

27. 2-26 © 2011 McGraw–Hill Ryerson Limited 15-26 © 2011 McGraw–Hill Ryerson Limited 16-26 © 2011 McGraw–Hill Ryerson Limited Summary: Taxes LO16.6 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.

28. 2-27 © 2011 McGraw–Hill Ryerson Limited 15-27 © 2011 McGraw–Hill Ryerson Limited 16-27 © 2011 McGraw–Hill Ryerson Limited Quick Quiz Why should stockholders care about maximizing firm value rather than just the value of the equity? How does financial leverage affect firm value without taxes? With taxes? What is homemade leverage?

29. 2-28 © 2011 McGraw–Hill Ryerson Limited 15-28 © 2011 McGraw–Hill Ryerson Limited 16-28 © 2011 McGraw–Hill Ryerson Limited 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”.