Capital Structure

Basic concepts: no taxes

Chapter 15 Capital Structure:

Basic Concepts

Capital-structure and pie theory

No-arbitrage pricing.

Example: shares for debt

Value

Required return on the levered firm.

Financial Leverage, EPS, and

ROE
Current
Proposed
Assets
$20,000$20,000
Debt
$0$8,000
Equity
$20,000$12,000
Debt/Equity
0.000.67
Interest rate
n/a8%
Shares
400
240
Share price
$50$50

Comments
Straight swap of equity for debt
Market prices unchanged
Real asset unchanged

Financial leverage and risk

Three states: bust, normal, boom.
Probabilities not explicit.
Look at each state separately.

EPS, ROE, Current Structure

Shares Outstanding = 400
Bust Normal
Boom
EBIT
$1,000$2,000$3,000
Interest
00
0
Net income $1,000$2,000$3,000
EPS
$2.50$5.00$7.50
ROA
5%10% 15%
ROE
5%10% 15%

EPS and ROE under

Proposed Capital Structure
Shares Outstanding = 240
Bust Normal
Boom
EBIT
$1,000$2,000$3,000
Interest
640640 640
Net income
$360$1,360$2,360
EPS
$1.50$5.67$9.83
ROA
5%10% 15%
ROE
3%11% 20%

Find the point of equal EPS

For understanding the situation, not

because it is a key to anything.
Let x = EBIT
Solve x/400 = (x - 640)/240
Solution x = 1600.
EPS = 4 per share, in either structure

12.00

Debt

10.00

Break-even
Point

EPS

8.00
6.00
4.00

No Debt

2.00
0.00

EBIT
1,000

(2.00)

2,000

3,000

Modigliani-Miller (MM) Model

Perpetual Cash Flows (convenient)

Firms and investors can borrow and
lend at the same rate (convenient)
Only value matters
No transaction costs (convenient)
No taxes

Homemade is a big concept

What financial managers do in the
firm
can be duplicated by investors in the
market
if they want to.
Implication: financial managers cant
raise value by restructuring.

Homemade leverage
Instead of the firm swapping equity for
debt.
The investor does it himself, by
borrowing.
It works out just as well.

Borrow $8000, buy the

unlevered firm for $20,000
Earnings
Interest at 8%
Net Profits
ROE (on $12K)

Bust Normal Boom

$1000 $2000 $3000
$640 $640 $640
$360 $1360 $2360
3% 11%
20%

Same as owning the levered firm

Okay, dont buy the whole firm

Buy 10%, forty shares for $2000.
Borrow $800.
Total cost $1200
Same as having 10% of the levered
firm, that is, 24 shares at $50 per
share.

Homemade annihilation of
leverage

Idea. Form a portfolio.

Part lending
part the levered firm.
Portfolio has the action of the unlevered
firm.
A levered firm is a portfolio.

Buy the levered firm (240

shares) and lend 8000
Cost of Portfolio = 12000 + 8000 = 20000
Boom Normal
Bust
EPS
$1.50$5.67$9.83
Earnings
$360$1360$2360
Interest at (8%)
$640$640$640
Net cash flow
$1000$2000$3000
ROE
5%10%15%
(Net cash flow / $2,000)

The firm is a veil

A way for shareholders to hold a

portfolio.

The MM Propositions I & II

(No Taxes)
P1: Value is unaffected by leverage
P1: VL = VU

P2: Leverage increases the risk and

return to stockholders
(formula to follow)

Proposition II of M-M

rB is the interest rate

rs is the return on (levered) equity

r0 is the return on unlevered equity

B is value of debt
SL is value of levered equity

rs = r0 + (B / SL) (r0 - rB)

Quick derivation of MM II
Uses MM I. Value unchanged.
Uses cash flow constraint.

MM I
Cash

SU S L B

r0 SU rS S L rB B

r0 ( S L B) rS S L rB B
rS S L r0 ( S L B ) rB B

rS S L r0 ( S L B ) rB B
rS S L r0 S L (r0 rB ) B
B
rS r0 (r0 rB )
SL

MM Proposition II no tax
Cost of
capital: r
(%)

r0

B
rS r0 (r0 rB )
SL

rS

rWACC
rB
Debt-toequity
ratio (B/S)

Exam review

What is the weighted average cost of

capital?

Answer

Dont tell us a story.

Give the definitions and the formula.
rB = bond rate

rS = expected return on shares

B = market value of bonds

S = market value of shares
TC = corporate tax rate

Pay-off pitch

WACC =
(S/(S+B))rS + (B/(S+B))(1-TC)rB