Capital Structure: Basic Concepts

1
Capital Structure Basic Concepts

• Lecture 4
• Saeid Samiei
• Portsmouth Business School

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 firms debt and the firms
  equity.
• V B S

• 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.

S
B
Value of the Firm
3
The Capital-Structure Question

• There are really two important questions
• Why should the stockholders care about maximizing
  firm value? Perhaps they should be interested in
  strategies that maximize shareholder value.
• What is the ratio of debt-to-equity that
  maximizes the shareholders value?
• As it turns out, changes in capital structure
  benefit the stockholders if and only if the value
  of the firm increases.

4
Financial Leverage, EPS, and ROE
Consider an all-equity firm that is considering
going into debt. (Maybe some of the original
shareholders want to cash out.)

• Current
• Assets 20,000
• Debt 0
• Equity 20,000
• Debt/Equity ratio 0.00
• Interest rate n/a
• Shares outstanding 400
• Share price 50

Proposed 20,000 8,000 12,000 2/3
8 240 50
5
EPS and ROE Under Current Capital Structure

• Recession Expected Expansion
• EBIT 1,000 2,000 3,000
• Interest 0 0 0
• Net income 1,000 2,000 3,000
• EPS 2.50 5.00 7.50
• ROA 5 10 15
• ROE 5 10 15
• Current Shares Outstanding 400 shares

6
EPS and ROE Under Proposed Capital Structure

• Recession Expected Expansion
• EBIT 1,000 2,000 3,000
• Interest 640 640 640
• Net income 360 1,360 2,360
• EPS 1.50 5.67 9.83
• ROA 5 10 15
• ROE 3 11 20
• Proposed Shares Outstanding 240 shares

7
EPS and ROE Under Both Capital Structures
All-Equity Recession Expected Expansion EBIT 1
,000 2,000 3,000 Interest 0 0 0 Net
income 1,000 2,000 3,000 EPS 2.50 5.00 7.50
ROA 5 10 15 ROE 5 10 15 Current Shares
Outstanding 400 shares

• Levered Recession Expected Expansion
• EBIT 1,000 2,000 3,000
• Interest 640 640 640
• Net income 360 1,360 2,360
• EPS 1.50 5.67 9.83
• ROA 5 10 15
• ROE 3 11 20
• Proposed Shares Outstanding 240 shares

8
Financial Leverage and EPS
12.00
Debt
10.00
8.00
No Debt
Advantage to debt
6.00
Break-even point
EPS
4.00
2.00
0.00
1,000
2,000
3,000
Disadvantage to debt
(2.00)
EBI in dollars, no taxes
EBIT
9
The Financing Mix Question

• Is there an optimal mix of debt and equity?
• If yes, what is the trade off that lets us
  determine this optimal mix?
• If not, why not?

10
The Modigliani Miller Proposition

• Both Modigliani Miller were awarded Nobel
  Prizes, in part, due to their work on capital
  structure
• What does the MM theory state
• Value irrelevance The value of a firm is
  independent of its leverage ratio.
• Leverage (gearing) ratio D/(DE)

11
MM thoughts

• Yogi Bear said "You better cut the pizza in four
  pieces because I'm not hungry enough to eat six."
• A dairy farmer cannot make more money by skimming
  the cream and selling it separately from the
  skimmed milk,
• even though the cream sells for a higher prices
  per kg than whole milk.

12
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

13
Homemade Leverage An Example
Recession Expected Expansion 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
14
Homemade (Un)Leverage An Example

• Recession Expected Expansion
• 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 firms
  debt gets us to the ROE of the unlevered firm.
• This is the fundamental insight of MM

15
The MM Propositions I II (No Taxes)

• Proposition I
• Firm value is not affected by leverage
• VL VU
• Proposition II
• Leverage increases the risk and return to
  stockholders
• rs r0 (B / SL) (r0 - rB)
• rB is the interest rate (cost of debt)
• rs is the return on (levered) equity (cost of
  equity)
• r0 is the return on unlevered equity (cost of
  capital)
• B is the value of debt
• SL is the value of levered equity

16
The MM Proposition I (No Taxes)
The derivation is straightforward
The present value of this stream of cash flows is
VL
The present value of this stream of cash flows is
VU
17
The MM Proposition II (No Taxes)
The derivation is straightforward
18
The Cost of Equity, the Cost of Debt, and the
Weighted Average Cost of Capital MM Proposition
II with No Corporate Taxes
Cost of capital r ()
r0
rB
rB
Debt-to-equity Ratio
19
The MM Propositions I II (with Corporate Taxes)

• Proposition I (with Corporate Taxes)
• Firm value increases with leverage
• VL VU TC B
• Proposition II (with Corporate Taxes)
• Some of the increase in equity risk and return is
  offset by interest tax shield
• rS r0 (B/S)(1-TC)(r0 - rB)
• rB is the interest rate (cost of debt)
• rS is the return on equity (cost of equity)
• r0 is the return on unlevered equity (cost of
  capital)
• B is the value of debt
• S is the value of levered equity

20
The MM Proposition I (Corp. Taxes)
The present value of this stream of cash flows is
VL
The present value of the first term is VU The
present value of the second term is TCB
21
The MM Proposition II (Corp. Taxes)
Start with MM 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
The Effect of Financial Leverage on the Cost of
Debt and Equity Capital
Cost of capital r()
r0
rB
Debt-to-equityratio (B/S)
23
Total Cash Flow to Investors Under Each Capital
Structure with Corp. Taxes
All-Equity Recession Expected Expansion EBIT 1
,000 2,000 3,000 Interest 0 0 0 EBT 1,000 2,00
0 3,000 Taxes (Tc 35 350 700 1,050 Total
Cash Flow to S/H 650 1,300 1,950

• Levered Recession Expected Expansion
• EBIT 1,000 2,000 3,000
• Interest (800 _at_ 8 ) 640 640 640
• EBT 360 1,360 2,360
• Taxes (Tc 35) 126 476 826
• Total Cash Flow 234640 468640 1,534640
• (to both S/H B/H) 874 1,524 2,174
• EBIT(1-Tc)TCrBB 650224 1,300224 1,95022
  4
• 874 1,524 2,174

24
Total Cash Flow to Investors Under Each Capital
Structure with Corp. Taxes
All-equity firm Levered firm
S
G
S
G
B
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.
25
Summary No Taxes

• In a world of no taxes, the value of the firm is
  unaffected by capital structure.
• This is MM Proposition I
• VL VU
• Prop I holds because shareholders can achieve any
  pattern of payouts they desire with homemade
  leverage.
• In a world of no taxes, MM Proposition II states
  that leverage increases the risk and return to
  stockholders

26
Summary Taxes

• In a world of taxes, but no bankruptcy costs, the
  value of the firm increases with leverage.
• This is MM Proposition I
• VL VU TC B
• Prop I holds because shareholders can achieve any
  pattern of payouts they desire with homemade
  leverage.
• In a world of taxes, MM Proposition II states
  that leverage increases the risk and return to
  stockholders.

27
Prospectus Bankruptcy Costs

• So far, we have seen MM 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 MM algebra.