1. McGraw-Hill/Irwin Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 15-0 Corporate Finance Ross  Westerfield  Jaffe Sixth Edition 15 Chapter Fifteen Capital Structure: Basic Concepts

2. McGraw-Hill/Irwin Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 15-1 Chapter Outline 15.1 The Capital-Structure Question and The Pie Theory 15.2 Maximizing Firm Value versus Maximizing Stockholder Interests 15.3 Financial Leverage and Firm Value: An Example 15.4 Modigliani and Miller: Proposition II (No Taxes) 15.5 Taxes 15.6 Summary and Conclusions

3. McGraw-Hill/Irwin Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 15-2 The Capital-Structure Question and The Pie Theory 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 Value of the Firm SB If the goal of the management of the firm is to make the firm as valuable as possible, the the firm should pick the debt-equity ratio that makes the pie as big as possible.

4. McGraw-Hill/Irwin Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 15-3 The Capital-Structure Question 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. McGraw-Hill/Irwin Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 15-4 Financial Leverage, EPS, and ROE 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.)

6. McGraw-Hill/Irwin Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 15-5 EPS and ROE Under Current Capital Structure 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

7. McGraw-Hill/Irwin Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 15-6 EPS and ROE Under Proposed Capital Structure RecessionExpectedExpansion EBIT$1,000$2,000$3,000 Interest640640640 Net income$360$1,360$2,360 EPS$1.50$5.67$9.83 ROA5%10%15% ROE3%11%20% Proposed Shares Outstanding = 240 shares

8. McGraw-Hill/Irwin Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 15-7 EPS and ROE Under Both Capital Structures Levered RecessionExpectedExpansion EBIT$1,000$2,000$3,000 Interest640640640 Net income$360$1,360$2,360 EPS$1.50$5.67$9.83 ROA5%10%15% ROE3%11%20% Proposed Shares Outstanding = 240 shares 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

9. McGraw-Hill/Irwin Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 15-8 Financial Leverage and EPS (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

10. McGraw-Hill/Irwin Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 15-9 Assumptions of the Modigliani-Miller Model 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

11. McGraw-Hill/Irwin Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 15-10 Homemade Leverage: An Example 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 / $1,200)3%11%20% 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:

12. McGraw-Hill/Irwin Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 15-11 Homemade (Un)Leverage: An Example 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

13. McGraw-Hill/Irwin Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 15-12 The MM Propositions I & II (No Taxes) Proposition I –Firm value is not affected by leverage V L = V U 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

14. McGraw-Hill/Irwin Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 15-13 The MM Proposition I (No Taxes) 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

15. McGraw-Hill/Irwin Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 15-14 The MM Proposition II (No Taxes) The derivation is straightforward:

16. McGraw-Hill/Irwin Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 15-15 The Cost of Equity, the Cost of Debt, and the Weighted Average Cost of Capital: MM Proposition II with No Corporate Taxes Debt-to-equity Ratio Cost of capital: r (%) r0r0 rBrB rBrB

17. McGraw-Hill/Irwin Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 15-16 The MM Propositions I & II (with Corporate Taxes) 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

18. McGraw-Hill/Irwin Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 15-17 The MM Proposition I (Corp. Taxes) 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

19. McGraw-Hill/Irwin Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 15-18 The MM Proposition II (Corp. Taxes) 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

20. McGraw-Hill/Irwin Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 15-19 The Effect of Financial Leverage on the Cost of Debt and Equity Capital Debt-to-equity ratio (B/S) Cost of capital: r (%) r0r0 rBrB

21. McGraw-Hill/Irwin Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 15-20 Total Cash Flow to Investors Under Each Capital Structure with Corp. Taxes 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 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

22. McGraw-Hill/Irwin Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 15-21 Total Cash Flow to Investors Under Each Capital Structure with Corp. Taxes 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

23. McGraw-Hill/Irwin Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 15-22 Summary: No Taxes 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

24. McGraw-Hill/Irwin Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 15-23 Summary: Taxes 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.

25. McGraw-Hill/Irwin Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 15-24 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”.