1. Capital Structure (How Much Debt?)
MBAC 6060 Chapter 16
Capital Structure
(How Much Debt?)

2. Chapter Overview WACC = WERE + WDRD(1 - T)
We looked a the return required by a company’s investors
It is the same as the company’s cost
It is the required return on the company’s investments
WACC = WERE + WDRD(1 - T)
WE and WD are the Percentages of Equity and Debt
RE and RD are the Costs of Equity and Debt

3. βEquity = βAssets (1 + D/E)
Chapter Overview
We also looked (in the context of the CAPM) at the effects of debt on Equity Risk
βEquity = βAssets (1 + D/E)
For a given risk of the firms assets (βAssets)
A function of cyclicality and operating leverage
How does the choice of debt level (D/E) change the risk of equity (βEquity)
So the Question is:
How much Debt should a firm have?
What should be the firm’s Capital Structure?
Capital Structure is defined by WE and WD
Sometimes D/E

4. Aside: Compare WD = D/V to D/E
If WD = D/V = 20% then calculate D/E:
E/V = 1 - D/V = 80%
D/E = (D/V)/(E/V) = 0.20/0.80 = 0.25
If WD = D/V = 50% then calculate D/E:
E/V = 1 - D/V = 50%
D/E = (D/V)/(E/V) = 0.50/0.50 = 1.00
If WD = D/V = 60% then calculate D/E:
E/V = 1 - D/V = 40%
D/E = (D/V)/(E/V) = 0.60/0.40 = 1.50

5. Chapter Overview WACC is the discount rate for all the firm’s projects
The lower the rate, the higher the value of the projects
A firm is the sum of its projects
So the higher the value of the firm
So how does WACC (and therefore firm value) change as WE and WD (or D/E) change?

6. Chapter Overview Definition: Adding Financial Leverage
Issue bonds to finance an expansion
Issue bonds and use the proceeds to buy back stock
Examine the effects of adding leverage:
The Value of the company
Value Unlevered (VU) versus the Value Levered (VL)
The Required Return on the Assets (RA)
The Required Return on the Equity (RE)
First assume no taxes
Second look at the effects of taxes

7. A = Assets or 0 = An All Stock firm
Notation:
In this chapter, the text book uses both:
D = Debt or B = Bond
and
E = Equity or S = Stock
A = Assets or 0 = An All Stock firm

8. But First: Corporate Dividend Policy
Covered in Chapter 19
Main Results:
The price of a stock decreases by the amount of a cash dividend
But, if instead of paying a dividend
Cash is used to repurchase shares
Then the share price increases by the amount that would have been paid

9. Example: Company has Earnings (NI) = $500,000
Number of Shares = 100,000
EPS = $5.00
Assume PE Ratio = 20x
PE accounts for current earnings, risk of earnings and NPVGO
Share Price given EPS = $5.00 x 20 = $100
Company also has $100,000 in Excess Cash
Excess Cash per Share = $100,000/100,000 = $1
Total Share Value = $100 + $1 = $101
Two Choices to pay Excess Cash to Shareholders:
Pay $1.00 per share dividend
Repurchase $100,000/$101 = 990 Shares

10. All Shareholders have = $100 share + $1 cash
Pay $1.00 per share dividend
Share Value before Dividend = $101
EPS = $5.00
PE Ratio = 20x
Share Price given Earnings = $5 x 20 = $100
Excess Cash per Share = $100,000/100,000 = $1
Share price = $101
After Dividend
Still have same current and expected earnings ($500,000)
Same number of Shares so EPS = $500,000/100,000 = $5
Same PE Ratio = 20
Paying excess cash does not change NPVGO
Share Value = $5 x 20 = $100
Plus $1 in cash
All Shareholders have = $100 share + $1 cash

11. 990 Shareholders have $101 in cash 99,010 Shareholders have $101 share
Repurchase $100,000/$101 = 990 Shares
Share Value before Repurchase = $101
EPS = $5.00
PE Ratio = 20x
Share Price given Earnings = $5 x 20 = $100
Excess Cash per Share = $100,000/100,000 = $1
Share price = $101
After Repurchase
Still have same current and expected earnings ($500,000)
Fewer Shares: 100,000 – 990 = 99,010 shares
So higher EPS = $500,000/99,010 = $5.05
Same PE Ratio = 20
Paying out Excess Cash does not change NPVGO
Share Value = $5.05 x 20 = $101
990 Shareholders have $101 in cash
99,010 Shareholders have $101 share

12. Price Drop from Cash Dividend – MSFT
On November 15, 2004, MSFT paid a $3.08 dividend

13. Dividends vs. Repurchases
(Figure 19.5 Page 582)

14. Now to Capital Structure What does adding Leverage do to:
The Required Return on the Equity (RE)
The Required Return on the Assets (RA)
The Value of the Company
Value Unlevered (VU) versus the Value Levered (VL)

15. Modigliani & Miller
These theories, formulas and propositions were developed by Franco Modigliani and Merton Miller
MM I (without Taxes)
“Changing how the pie is sliced does not make it any bigger.”
A firm’s total value is not affected by its capital structure:
VL = VU
MM II (without Taxes)
Changing capital structure does increase equity risk and equity return but does not change the WACC
RE = RA + (RA – RD)D/E
MM I (with Taxes):
With taxes, adding debt does increase firm value. Firm value does depend on its capital structure:
VL = VU + TC x D
MM II (with Taxes):
With taxes Leverage increases equity risk and equity return and does decrease WACC.
RE = RA + (RA – RD)(1 – TC)D/E

16. ValueLevered = ValueUnlevered
First Results (no Taxes):
ValueLevered = ValueUnlevered
VL = VU
The value of the firm does not increase with the addition of leverage
Changing the way the pie is sliced does not increase the slice of the pie
People can borrow just as easily as the company
Result:
A company can’t create value just by replicating what people can do on their own
This result is know as MM I

17. MM I without Taxes: Levering Does Not Create Value
A company can’t create value just by replicating what people can do on their own
Show this by comparing a persons returns from
Owning a levered firm
Increasing ownership in an Unlevered firm by borrowing
Called “homemade leverage”
This is shown in Example 16.1

18. Example 16.1 Unlevered Firm Levered Firm
The Unlevered Firm has $0 debt
A share price of $20
And EPS of $1, $3 or $5
The Levered Firm has $4,000 debt
And EPS of $0, $4 or $8
Putting up $2,000 to buy 100 share of the Levered Firm produces returns of
$0/$2,000 = 0%
$400/$2,000 = 20%
$800/$2,000 = 40%
Putting up $2,000 and Borrowing $2,000 to buy 200 share of the Unlevered Firm produces returns of 0%, 20% or 40%
Since the returns available to an owner of the Levered Firm are easily replicated by an individual borrowing and buying shares of the Unlevered Firm, firms create no value by levering
Unlevered Firm
Levered Firm
Assets
$8,000
Debt $0
$4,000
Equity
Borrow Rate
10%
Price/Share
$20
Shares
400
200
Units Sold
100
300
500
Sales
$1,000
$3,000
$5,000
Costs
$600
$1,800
EBIT
$400
$1,200
$2,000
Int Exp
EBT
$800
$1,600
Tax Exp NI
EPS $1 $3 $5 $4 $8
Own the Unlevered Firm
Own the Levered Firm
Shares Owned
Cost
Borrow
Out of Pocket
Shares x EPS
$200
Net Payoff
Return 0%
20%
40%

19. Second Result (still no Taxes): RE = RA + (RA – RD)D/E
RA is the required return on the firm’s assets
RA is function of cyclicality and operating leverage
RD is the required return on the firm’s debt
RD is a function of the risk of the assets and the amount of debt
We cover this later
D/E is the measure of leverage
RE is the required return on the firm’s equity
Result:
RE increases as leverage increases
This result is know as MM II

20. Derivation:
WACC = WERE + WDRD
RA = WERE + WDRD
RA = (E/V) RE + (D/V) RD
RA = E/(D + E)RE + D/(D + E) RD
Do a bunch of Algebra.
See footnote 8,page 497
RE = RA + (RA – RD)D/E

21. Example: An Unlevered Firm earns $100 per year forever
Unlevered means D/E = 0
No Interest Expense and No Taxes
 EBIT = EBT = NI = $100
The firm has 100 shares of stock
EPS = $100/100 = $1
Price per share = $10
RE = $1/$10 = 10%
RE = RA + (RA – RD)D/E
 10% = RA + 0  RA = 10%
Firm Value = 100 x $10 = $100/0.10 = $1,000
If the firm issues $200 of 5% debt and repurchases $200 of stock
What does this do to the firm’s cost of equity (RE)?
What does this do the firm’s WACC?
What does this do to the firm’s value (VL versus VU)?

22. Leverage increases the Equity’s risk so RE Increases!
What does this do to the firm’s cost of equity (RE)?
If the firm issues $200 of 5% debt and repurchases $200 of stock:
EBIT = $100
Assets, AT and PM did not change
Interest Expense = $200 x 5% = $10
EBT = NI = EBIT – Interest Expense = $100 - $10 = $90
$90 per year forever
New Shares = $200/$10 = 100 – 20 = 80
New EPS = NI/Shares = $90/80 = $1.125
New RE = $1.125/$10 = 11.25% OR
RE = RA + (RA – RD)D/E
D/E = $200/$800 = 0.25
RA = 10%
The firm’s assets did not change
RE = 10% + (10% – 5%)0.25 = 11.25%
Leverage increases the Equity’s risk so RE Increases!

23. WACC does not change! What does this do to the firm’s WACC?
Before the Leverage:
RE = 10.00%
WE = 1.00
No Taxes (yet)
WACC = WERE + WDRD(1 - T)
WACC = 1.00(10.00%) + 0 = 10.00%
If the firm issues $200 of 5% debt and repurchases $200 of stock:
RE = 11.25%
WE = $800/$1,000 = 0.80
RD = 5.00%
WD = $200/$1,000 = 0.20
Still No Taxes (yet)
WACC = 0.80(11.25%) (5.00%) = 10.00%
WACC does not change!

24. Firm Value Does Not Change!
What does this do to the firm’s Value?
Firm Value is the NPV of all the firm’s projects
The WACC does not change so the discount rate does not change
If the discount rate does not change, then the NPVs do not change
Firm Value Does Not Change!
Recap:
MM I without Taxes: VL = VU
MM II without Taxes: RE = RA + (RA – RD)D/E
The Point:
Financing decisions do not create value
Operating decisions create value!

25. Now Included Taxes: First consider the Value of a Levered Firm
Since Interest payments are tax deductable
Example:
A firm’s EBIT = $100
Tax Rate = 35%
With no Debt and therefore no Interest Expense:
EBIT = EBT = $100
Tax Expense = $100 x 0.35 = $35
NI = $100 - $35 =$65 OR
NI = EBIT(1 – T) = $100(1 – 0.35) = $65
So $65 per year to give to investors

26. With Taxes, Debt Increases Money Available to Stakeholders
Now Assume $200 of 5% Debt:
RD = 5%
EBIT = $100
Interest Expense = 0.05 x $200 = $10
EBT = $100 - $10 = $90
Tax Expense = $90 x 0.35 = $31.50
NI = EBT – Tax Exp = $90 - $31.50 = $58.50 OR
NI = (EBIT – RDD) - (EBIT – RDD)T
NI = (EBIT – RDD)(1 –T)
NI = ($100 – 0.05 x $200)(1 – 0.35) = $58.50
NI = ($90)(0.65) = 58.50
$58.50 to Equity holders and $10 to Debt holders
$ $10 = $68.50
Total CFs No Debt = NI = $65
Total CFs debt = NI + Interest Expense = $ $10 = $68.50
With Taxes, Debt Increases Money Available to Stakeholders

27. Debt Creates a Tax Shield
D = $ RD = 5% T = 35%
CF to Equity holders = NI
NI = (EBIT – RDD)(1 –T)
NI = EBIT(1 – T) – RDD(1 –T)
NI = EBIT(1 – T) – RDD + TRDD
CF to Debt holders = Interest Expense
Interest Expense = RDD
Total CFs to Equity and Debt holders
Total CFs = EBIT(1 – T) – RDD + TRDD + RDD
Total CFs = EBIT(1 – T) + TRDD
Unlevered: Total CFs = EBIT(1 – T)
Levered: Total CFs = EBIT(1 – T) + TRDD
TRDD is the increase in CFs from adding debt.
It is the annual tax savings or tax shield
So what is it worth?
TRDD = (0.35)(0.05)($200) = $3.50
Recall: $ $65 = $3.50

28. With Taxes, Adding Debt Increases Firm Value
Debt Creates a Tax Shield
Unlevered:
Total CFs = EBIT(1 – T) = $65
Levered:
Total CFs = EBIT(1 – T) + TRDD = $65 + $3.50 = $68.50
TRDD is the annual increase in Total CFs from adding debt
Assume T, Debt and RD are constant forever
Then the Tax Shield is a perpetuity
At what rate should we discount the perpetuity?
Assume the tax savings has the same risk as the debt
So discount the annual Tax Shield at RD
So if Tax Shield is a perpetuity discounted by RD,
Then the PV of the Tax Shield is:
PV of Tax Shield = TRDD/RD = TD
MM I with Taxes: VL = VU + TC x D
With Taxes, Adding Debt Increases Firm Value

29. What Happens to Equity Risk and Return? Equity Risk:
Without Taxes: βEquity = βAssets (1 + D/E)
With Taxes: βEquity = βAssets [1 + (1 - T)D/E]
(See Chapter 13, footnote 6, page 405)
Equity Return:
Without Taxes: RE = RA + (RA – RD)D/E
With Taxes: RE = RA + (RA – RD)(1 – T)D/E

30. New Example: An Unlevered Firm earns $100 per year forever
Calculate the RE and WACC:
Unlevered means D/E = 0
No Interest Expense
So EBIT = EBT = $100
Taxes = 35%
NI = EBIT(1 – T) = $100(1 – 0.35) = $65
The firm has 100 shares of stock
EPS = $65/100 = $0.65
Price per share = $6.50
RE = $0.65/$6.50 = 10%
WACC = RA = WERE + WDRD(1 - T) = 1.00(10.00%) + 0 = 10.00%
Value = $6.50 x 100 = $650
The firm issues $200 of 5% debt and repurchases $200 of stock
What does this do to the firm’s value (VL versus VU)?
What does this do to the firm’s cost of equity (RE)?
What does this do the firm’s WACC?

31. With Taxes, Adding Debt Increases Firm Value
What does this do to the firm’s Value?
Unlevered Value (VU) is the PV of the after-tax EBIT
T = 35%
D = $200
RD = 5%
VU = EBIT(1 – T)/WACC = $100(1 – 0.35)/0.10 = $650
VL = VU + PV of Tax Shield
Recall:
Annual Tax Shield = Tax Rate x Interest Expense = RD x D x T
PV of Annual Tax Shield = (RD x D x T)/RD = TD
VL = VU + TD
VL = $650 + $200 x 0.35 = $650 + $70 = $720
With Taxes, Adding Debt Increases Firm Value

32. Leverage increases the Equity’s risk so RE Increases
What does this do to the firm’s cost of equity (RE)?
Calculate the New RE: for the Levered Firm:
RE = RA + (RA – RD)(1 – T)D/E
RA = 10.00%
RD = 5.00%
T = 35%
Value = $720
D = $200
E = $720 - $200 = $520
D/E = 200/520 =
= 10% + (10% - 5%)( ) = 11.25%
Unlevered RE = 10.00%
Levered RE = 11.25%
Leverage increases the Equity’s risk so RE Increases

33. Leverage Lowers the Cost of Capital!
What does this do to the firm’s WACC?
Before the Leverage:
RE = 10.00%
WE = 1.00
Taxes = 35%
WACC = WERE + WDRD(1 - T)
WACC = 1.00(10.00%) + 0 = 10.00%
If the firm issues $200 of 5% debt and repurchases $200 of stock:
RE = 11.25%
WE = $520/$720 =
RD = 5.00%
WD = $200/$720 =
T = 35%
WACC = (11.25%) (5.00%)(1 – 0.35) = 9.03%
Leverage Lowers the Cost of Capital!

34. With Taxes, Adding Debt Lowers WACC And this Increases Firm Value
One More Look at Value – Lowering the WACC
Unlevered WACC was 10%
VU = EBIT(1 – T)/WACC
VU = $100(1 – 0.35)/0.10 = 65/0.10 = $650
Levered WACC is 9.03%
VL = EBIT(1 – T)/WACC
VL = $100(1 – 0.35)/ = 65/ = $720
With Taxes, Adding Debt Lowers WACC
And this Increases Firm Value

35. One More Look at the Firm’s Cost of Equity (RE)
Consider the CAPM:
RE = Rf + βEquity[E(RM) – Rf]
For the Market:
E(RM) – Rf = 8.33%
Rf = 5.00%
RE for the Unlevered Firm:
βEquity = 0.60
RE = Rf + βEquity[E(RM) – Rf] = 5.00% [8.33%] = 10.00%
Also:
βEquity = βAssets [1 + (1 - T)D/E]
0.60 = βAssets [1 + (1 - T)0/E]
βAssets = 0.60

36. One More Look at the Firm’s Cost of Equity (RE) For the Levered Firm
D/E = 200/520 =
βAssets = 0.60
βEquity = βAssets [1 + (1 - T)D/E] = 0.60[1 + (0.65)(0.3846)]
βEquity = 0.60[ ] = 0.60(1.25) = 0.75
RE = Rf + βEquity[E(RM) – Rf] = 5.00% [8.33%] = 11.25%
This is the same RE as we got from MM II:
RE = RA + (RA – RD)(1 – T)D/E
= 10% + (10% - 5%)( ) = 11.25%

37. Recap: With Taxes: Leverage Increases Equity Risk (βEquity)
βEquity = βAssets [1 + (1 - T)D/E]
βEquity from 0.60 to 0.75
Leverage Increases Equity Return (RE)
RE = RA + (RA – RD)(1 – T)D/E
RE from 10.00% to 11.25%
Leverage Decreases WACC
WACC from 10.00% to 9.03%
Leverage Increases Value
VL = VU + TD
Value from $650 to $720

38. So if Increasing Leverage Increases Value
Why not 100% Debt?
Let’s try 90% debt instead:
Same Company with NI = $65 and VU = $650
Now issue $854 of 5% Debt (instead of $200)
VL = VU + TD = $650 + (.35)$854 = $650 + $299 = $949
E = $949 – $854 = $95
WE = $95/$949 = and WD = 854/949 = 0.90
D/E = $854/$95 = 9.00
Calculate New RE:
RE = RA + (RA – RD)(1 – T)D/E = 10% + (10% - 5%)(.65)9 = 39.22%
Calculate New WACC:
WACC = 0.10(39.22%) (5%)(1 – 0.35) = 6.85%
WACC from 10.00% to 6.85%
Old Value: $65/0.10 = $650
New Value: $65/ = $948
Why does this not work?

39. How Firms Establish Capital Structure
Most corporations have low Debt-Asset ratios.
Changes in financial leverage affect firm value.
Firm value increases with leverage
This is consistent with M&M with taxes.
Another interpretation is that firms signal good news when they lever up
Differences in capital structure across industries.
Evidence that firms behave as if they had a target Debt-Equity ratio

40. Factors in Target D/E Ratio
Taxes
Since interest is tax deductible, highly profitable firms should use more debt (i.e., greater tax benefit).
Types of Assets
The costs of financial distress depend on the types of assets the firm has.
Airplanes vs. Fixed Assets
Uncertainty of Operating Income
Cyclicality and Operating Leverage
Even without debt, firms with uncertain operating income have a high probability of experiencing financial distress

41. Some Debt to Value Ratios

42. Some Others