Chapter 14

Capital
Structure in a
Perfect Market

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 Chapter Outline

14.1 Equity Versus Debt Financing

14.2 Modigliani-Miller I: Leverage, Arbitrage,
and Firm Value
14.3 Modigliani-Miller II: Leverage, Risk, and
the Cost of Capital

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 14.1 Equity Versus Debt
Financing

• Capital Structure
– The relative proportions of debt, equity, and
other securities that a firm has outstanding

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 Capital Restructuring

• We are going to look at how changes in capital

structure affect the value of the firm, all else
equal
• Capital restructuring involves changing the
amount of leverage a firm has without
changing the firm’s assets
• The firm can increase leverage by issuing debt
and repurchasing outstanding shares
• The firm can decrease leverage by issuing new
shares and retiring outstanding debt

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 Choosing a Capital Structure

• What is the primary goal of financial

managers?
– Maximize stockholder wealth
• We want to choose the capital structure
that will maximize stockholder wealth
• We can maximize stockholder wealth by
maximizing the value of the firm or
minimizing the WACC

Note: WACC is the appropriate discount rate for the risk of the firm’s assets. We can find the
value of the firm by discounting the firm’s expected future cash flows at the discount rate – the
process is the same as finding the value of anything else. Since value and discount rate move in
opposite directions, firm value will be maximized when WACC is minimized.

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 The Effect of Leverage

• How does leverage affect the EPS and ROE of a firm?

• When we increase the amount of debt financing, we
increase the fixed interest expense
• If we have a really good year, then we pay our fixed
cost and we have more left over for our stockholders
• If we have a really bad year, we still have to pay our
fixed costs and we have less left over for our
stockholders
• Leverage amplifies the variation in both EPS and ROE

Note: if we increase the amount of debt in a restructuring, we are decreasing the

amount of outstanding shares.

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 Example: Financial Leverage, EPS
and ROE – Part I

• We will ignore the effect of taxes at this stage

• What happens to EPS and ROE when we issue
debt and buy back shares of stock?
$4.00
Financial Leverage:
Break-even
$2.00 EPS and EBIT for the

EPS
Point:
EPS = $1;
Trans
EBIT =
$500,000
Am Corpora-
$0.00 tion
$300,00 $650,00 $1,000,
EBIT
0 0 000

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 Example: Financial Leverage, EPS
and ROE – Part I

Current Proposed
Assets $5,000,000 $5,000,000
Debt $0 $2,500,000
Equity $5,000,000 $2,500,000
Debt/Equity Ratio 0 1
Share Price $10 $10
Shares Outstanding 500,000 250,000
Interest rate N/A 10%

Current Capital Structure: No Debt

Recession Expected Expansion

EBIT $300,000 $650,000 $1,000,000

Interest 0 0 0

Net Income $300,000 $650,000 $1,000,000

ROE 6.00% 13.00% 20.00%
EPS $0.60 $1.30 $2.00

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 Example: Financial Leverage, EPS
and ROE – Part II
Current Proposed
Assets $5,000,000 $5,000,000
Debt $0 $2,500,000
Equity $5,000,000 $2,500,000
Debt/Equity Ratio 0 1
Share Price $10 $10
Shares Outstanding 500,000 250,000
Interest rate N/A 10%

Proposed Capital Structure: Debt = $4 million

Recession Expected Expansion

EBIT $300,000 $650,000 $1,000,000

Interest 250,000 250,000 250,000

Net Income $50,000 $400,000 $750,000

ROE 2.00% 16.00% 30.00%
EPS $0.20 $1.60 $3.00

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 Example: Financial Leverage, EPS
and ROE – Part II

• Variability in ROE
– Current: ROE ranges from 6% to 20%
– Proposed: ROE ranges from 2% to 30%
• Variability in EPS
– Current: EPS ranges from $0.60 to $2.00
– Proposed: EPS ranges from $0.20 to $3.00
• The variability in both ROE and EPS increases
when financial leverage is increased

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 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.

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 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.)

The firm borrows $8,000 and buys back 160 shares at $50 per share.
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 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

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 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 1.8% 6.8% 11.8%
ROE 3% 11% 20%

Proposed Shares Outstanding = 240 shares

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 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 1.8% 6.8% 11.8%
ROE 3% 11% 20%
Proposed Shares Outstanding = 240 shares

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 Financial Leverage and EPS
12.00

10.00 Debt

8.00 No Debt

6.00 Break-even Advantage

EPS

point to debt
4.00

2.00 Disadvantage
to debt
0.00
1,000 2,000 3,000
(2.00) EBIT in dollars, no taxes

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 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

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 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:
B $800 2
= =
S $1, 200 3

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 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 firm’s debt gets us to the ROE of the
unlevered firm.
This is the fundamental insight of M&M

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 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

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 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 (%)

B
rS  r0   (r0  rB )
SL

B S
r0 rW ACC   rB   rS
BS BS

rB rB

B
Debt-to-equity Ratio S

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 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
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 The Effect of Financial Leverage on the
Cost of Debt and Equity Capital with
Corporate Taxes
Cost of capital: r B
(%)
rS  r0   (r0  rB )
SL

B
rS  r0   (1  TC )  (r0  rB )
SL

r0

B SL
rW ACC   rB  (1  TC )   rS
BSL B  SL
rB

Debt-to-equity
ratio (B/S)
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 Total Cash Flow to Investors Under
Each Capital Structure with Corp.
Taxes
All-equity firm Levered firm

S G S G

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.
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 Total Cash Flow to Investors Under
Each Capital Structure with Corp.
Taxes

All-equity firm Levered firm

S G S G

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!
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