Financial Leverage and Capital

Structure
• The Capital Structure Question
• The Effect of Financial Leverage
• Capital Structure and the Cost of Equity
Capital
• M&M Propositions I and II with Corporate
Taxes
• Insolvency Costs
• Optimal Capital Structure
• The Pecking Order Theory

1 © The McGraw-Hill Companies, 2004

 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
• Increase leverage by issuing debt and
repurchasing outstanding shares
• Decrease leverage by issuing new shares and
retiring outstanding debt

2 © The McGraw-Hill Companies, 2004

 Choosing a Capital Structure

• What is the primary goal of financial

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

3 © The McGraw-Hill Companies, 2004

 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
shareholders
• If we have a really bad year, we still have to
pay our fixed costs and we have less left over
for our shareholders
• Leverage amplifies the variation in both EPS
and ROE 4 ©
The McGraw-Hill Companies, 2004
 Example: Financial Leverage,
EPS and ROE
• We will ignore the effect of taxes at this stage
• What happens to EPS and ROE when we issue debt and buy
back shares?
Current Proposed

Assets R8 000 000 R8 000 000

Debt R0 R4 000 000

Equity R8 000 000 R4 000 000

Debt/Equity ratio 0 1
Share price R20 R20
Share in issue 400 000 200 000
Interest rate 10% 10%

5 © The McGraw-Hill Companies, 2004

 Example: Financial Leverage, EPS
and ROE (cont’d)
Current Capital Structure: no debt

Recessio Expected Expansion

n
PBIT R500 000 R1 000 R1 500
000 000
Interest 0 0 0
Net profit R500 000 R1 000 R1 500
000 000
ROE 6.25% 12.5% 18.75%
EPS R1.25 R2.50
6 ©
R3.75
The McGraw-Hill Companies, 2004
 Example: Financial Leverage, EPS
and ROE (cont’d)
Proposed Capital Structure: debt = R4
million
Recessio Expected Expansion
n
PBIT R500 000 R1 000 R1 500
000 000
Interest R400 000 R400 000 R400 000
Net profit R100 000 R600 000 R1 100
000
ROE 2.5% 15.00% 27.5%
7
EPS R0.5 R3.00© R5.50
The McGraw-Hill Companies, 2004
Example: Financial Leverage, EPS
and ROE (cont’d)

• Variability in ROE
– Current: ROE ranges from 6,25% to 18,75%
– Proposed: ROE ranges from 2,50% to
27,50%
• Variability in EPS
– Current: EPS ranges from R1,25 to R3,75
– Proposed: EPS ranges from R0,50 to R5,50
• The variability in both ROE and EPS
increases when financial leverage is
increased
8 © The McGraw-Hill Companies, 2004
 Break-Even PBIT

• Find PBIT where EPS is the same under

both the current and proposed capital
structures
• If we expect PBIT to be greater than the
break-even point, then leverage is
beneficial to our stockholders
• If we expect PBIT to be less than the
break-even point, then leverage is
detrimental to our stockholders
9 © The McGraw-Hill Companies, 2004
 Example: Break-Even PBIT
PBIT PBIT  400000

400000 200000
 400000
PBIT   PBIT  400000
 200000
PBIT 2PBIT 800000
PBIT R800000
800000
EPS  R2,00
400000

10 © The McGraw-Hill Companies, 2004

EPS and PBIT for the Trans Africa
Company

11 © The McGraw-Hill Companies, 2004

 Exercise
Pierce Corp. is looking at two possible capital structures.
Currently, the firm is an all-equity firm with E1.2 million
dollars in assets and 200,000 shares outstanding. The
market value of each stock is E6.00. The CEO of Pierce is
thinking of leveraging the firm by selling E600,000 of
debt financing. The cost of debt is 8% annually, and the
current corporate tax rate for Pierce is 30%.

• What is the break-even EBIT for Pierce with

these two possible capital structures?

© The McGraw-Hill Companies, 2004

 Solution
• Set the EPS of the two capital structures
equal to each other and solve for EBIT.

• The first step is to find the annual interest

expense: Annual Interest Payment for Debt =
E600,000 × 0.08 = E48,000.

• The second step is to determine the number of

shares that will be retired with the E600,000
raised through the sale of debt. Shares retired
equal the debt funding divided by the current
share price, E600,000 / E6.00 = 100,000.

© The McGraw-Hill Companies, 2004

 ……Cont
The third step is to set the earnings per share of the two capital structures
equal to each other. Earnings per share for the all-equity capital structure
are the EBIT - Taxes divided by the number of shares outstanding:

• EPS all-equity firm = EBIT × (1 - 0.30) / 200,000.

• Earnings per share for the leveraged capital structure are (EBIT - Interest
- Taxes) / shares outstanding:

• EPS leveraged firm = [(EBIT - E48,000) × (1 - 0.30)] / 100,000.

© The McGraw-Hill Companies, 2004

 ….Cont
• Setting the two EPS equations equal and solving for EBIT we have,

EBIT × (1 - 0.30) / 200,000 = [(EBIT -

E48,000) × (1 - 0.30)] / 100,000.
Solving for EBIT we find:
• (EBIT × 0.70) × 100,000 = [(EBIT × 0.70) - E33,600] × 200,000;
• EBIT × 0.70 = [(EBIT × 0.70) - E33,600] × 2;
• EBIT × 0.70 = 2 × (EBIT × 0.70) - E67,200;
• EBIT × 0.70 = E67,200;
• EBIT = E67,200 / 0.70 = E96,000 as the break-even EBIT

© The McGraw-Hill Companies, 2004

 Further Practice
• Landry Corp. is looking at two possible capital
structures. Currently, the firm is an all-equity firm
with E1.2 million dollars in assets and 200,000
shares outstanding. The market value of each
stock is E6.00. The CEO of Landry is thinking of
leveraging the firm by selling E600,000 of debt
financing and retiring 100,000 shares, leaving
100,000 outstanding. The cost of debt is 10%
annually, and the current corporate tax rate for
Landry is 30%.

• If the CEO believes that Landry's EBIT will be

E120,000, should the CEO leverage the firm?
Explain.
© The McGraw-Hill Companies, 2004
 Further Practice
• Find the EPS under the two financing structures with an EBIT of E120,000:
• With All-Equity:
EPS = E120,000 (1 – 0.3) = E0.42
200,000
• Annual Interest Payment for Debt = E600,000 × 0.10 = E60,000.
• With 50/50 Debt-to-Equity:
EPS = (E120,000 - E60,000) x (1 – 0.3) = E0.42
• Because the earnings per share are the same, the shareholders will be
indifferent as to whether the CEO chooses E600,000 in debt financing versus a
firm that is all-equity. Thus, it does not matter what the CEO chooses.

© The McGraw-Hill Companies, 2004

 Further Practice
• Garson Corp. is looking at two possible capital structures. Currently,
the firm is an all-equity firm with E1.2 million dollars in assets and
200,000 shares outstanding. The market value of each share of stock is
E6.00. The CEO of Garson is thinking of leveraging the firm by selling
E600,000 of debt financing and retiring 100,000 shares, leaving
100,000 outstanding. The cost of debt is 10% annually, and the current
corporate tax rate for Garson is 30%.

• If the CEO believes that Garson will earn E100,000 per year before
interest and taxes, should she leverage the firm? Explain.

© The McGraw-Hill Companies, 2004

 Further Practice
• Find the EPS under the two financing structures with an EBIT of
E100,000:
• With All-Equity:
• EPS = E100,000 (1 – 0.3) = E0.35
200,000
• Annual Interest Payment for Debt = E600,000 × 0.10 = E60,000.

• With 50/50 Debt-to-Equity:

• EPS = [(E100,000 - E60,000)] x (1 – 0.3) = E0.28.
100,000

© The McGraw-Hill Companies, 2004

 Further Practice

• So the shareholders will be worse off by E0.07

per share under a firm with E600,000 in debt
financing versus a firm that is all-equity.

• The CEO of Garson Corp. should NOT add this

much debt to the firm as it would not benefit
the owners of the company.

• The CEO might look at smaller amounts of debt

to determine if debt can be valuable.

• Smaller amounts of debt might lower the cost

of debt borrowing and make leverage value-
enhancing for shareholders.

© The McGraw-Hill Companies, 2004

 Capital Structure Theory
• Modigliani and Miller Theory of Capital
Structure
– Proposition I – firm value
– Proposition II – WACC
• The value of the firm is determined by the
cash flows to the firm and the risk of the
assets
• Changing firm value
– Change the risk of the cash flows
– Change the cash flows

21 © The McGraw-Hill Companies, 2004

 Capital Structure Theory Under
Three Special Cases
• Case I – Assumptions
– No corporate or personal taxes
– No insolvency costs
• Case II – Assumptions
– Corporate taxes, but no personal taxes
– No insolvency costs
• Case III – Assumptions
– Corporate taxes, but no personal taxes
– insolvency costs

22 © The McGraw-Hill Companies, 2004

Modigliani and Miller Theory: General
Assumptions
• The investment and dividend decisions are
independent of the capital structure decision.
• The capital structure is flexible.
• Investors are rational and behave accordingly.
• Investors have the same expectations about
the future.
• Firms can be categorised into homogeneous
(equivalent) risk classes.
• No agency costs or limited liability.

23 © The McGraw-Hill Companies, 2004

Modigliani and Miller Theory: General
Assumptions (cont’d)
• Perfect capital markets
– Equal, costless access to all relevant
information
– Individuals and companies can borrow and
lend at the same rate
– Perfect competition – everyone is a price
taker
– No transactions costs
– No bankruptcy or financial distress costs
– No taxes or corporate and personal taxes
are the same
• Constant perpetual cash24 flows (i.e. no
© The McGraw-Hill Companies, 2004
growth)
 Modigliani and Miller Proposition 1
without taxes
• Proposition I
– The value of the firm is NOT affected by changes in the
capital structure.
– The cash flows of the firm do not change, therefore value
doesn’t change.
– The value of the firm is independent from its capital
structure, therefore the value of levered firm will be equal
to the value of otherwise identical unlevered firm.

• In the absence of taxes (both corporate and personal) and

other unpleasantries like insolvency costs:
– Corollary #1: the value of the firm is unaffected by its
financial policy.
– Corollary #2: there is no “magic” in finance.
– Corollary #3: capital restructuring don’t create value.
– Corollary #4: WACC remains constant under any capital
structure
The value/size of a pie is not determined by how it is
sliced. 25 © The McGraw-Hill Companies, 2004
 Figure 16.2
Pie models of capital structure

26 © The McGraw-Hill Companies, 2004

 M&M Proposition I
Earnings before
Market value of interest and taxes
equity EBIT
V= E  D  =
r
Market value of
Required return on
debt
assets

HTMC expected EBIT is €1,000,000 and required

return on assets is 10%.
HTMC value
with both
initial and
proposed
capital
structure
© The McGraw-Hill Companies, 2004
Modigliani and Miller Proposition II without
taxes
• Required return on the firm’s equity capital is a
positive linear function of its capital structure.
• Because of Proposition I, the WACC must be constant.
With no taxes,
WACC = RA = (E/V)RE + (D/V)RD
Rearranging and making RA or WACC the subject of the
formula
RE = RA + (RA – RD)(D/E)
Thus the cost of equity has two parts:
– RA is the “cost” of the firm’s business risk, i.e., the
risk of the firm’s assets
– (RA – RD)(D/E) is the “cost” of the firm’s financial
risk, i.e., the additional return required by
stockholders to compensate for the risk of leverage
28 © The McGraw-Hill Companies, 2004
MM Proposition II without taxes

29 © The McGraw-Hill Companies, 2004

 Example
• Data
– Required return on assets = 16%, cost of debt =
10%; percent of debt = 45%
• What is the cost of equity?
RE = RA + (RA - RD) x (D/E)
– RE = 0,16 + (0,16 – 0,10)(0,45/0,55) = 0,2091 =
20,91%
• Suppose instead that the cost of equity is 25%,
what is the debt-to-equity ratio?
– 0,25 = 0,16 + (0,16 – 0,10)(D/E)
– D/E = (0,25 – 0,16) / (0,16 – 0,10) = 1,5
• Based on this information, what is the percent of
equity in the firm?
– E/V = 1 / 2,5 = 40%
30 © The McGraw-Hill Companies, 2004
 MM Proposition II without taxes

• MM’s conclusion is that the introduction of

more “cheap” debt is perfectly offset by the
corresponding increase in the required return
on equity. Therefore, WACC is constant.
OR
• The change in the capital structure weights
(E/V and D/V) is exactly offset by the change in
the cost of equity (RE), so the WACC stays the
same.

31 © The McGraw-Hill Companies, 2004

The CAPM, the SML and Proposition
II
• How does financial leverage affect systematic risk?
• CAPM: RA = Rf + A(RM – Rf)
– Where A is the firm’s asset beta and measures the
systematic risk of the firm’s assets
– It is also called the unlevered beta because it is the
beta that the share would have if the firm had no
debt.
• The cost of equity under SML
• RE = Rf + (RM – Rf)E
• Proposition II
– Replace RA with the CAPM and assume that the debt
is riskless (RD = Rf)
– RE = Rf + A(1+D/E)(RM – Rf)
32 © The McGraw-Hill Companies, 2004
 The CAPM, the SML and
Proposition II
• Combine the SML and MM Proposition II
• RE = Rf + A(1+D/E)(RM – Rf)
• CAPM: RE = Rf + E(RM – Rf)
– E = A(1 + D/E)
– A – the unlevered asset beta
– (1 + D/E) – the equity multiplier
– The risk premium on the firm’s equity = the
risk premium on the firm’s assets X the
Equity Multiplier
33 © The McGraw-Hill Companies, 2004
Business Risk and Financial Risk

– Therefore, the total systematic risk of the

firm’s equity has two parts :
– Systematic risk of the assets, A, (Business
risk) – the equity risk that comes from the
nature of the firm’s operating activities.
– Level of leverage, D/E, (Financial risk) – the
equity risk that comes from the financial
policy (i.e. capital structure) of the firm.

34 © The McGraw-Hill Companies, 2004

 M&M with Taxes
• Most countries allow firms to deduct interest as
an expense, but not dividends.
• Interest is tax deductible - Deductibility lowers
the after-tax cost of debt.
• Therefore, when a firm adds debt, it reduces
taxes, all else equal
• The reduction in taxes increases the cash flow of
the firm - By using more debt, firms shelter more
cash flows from taxes
• How should an increase in cash flows affect the
value of the firm?
• By using more debt, firms shelter more cash
flows from taxes
35 © The McGraw-Hill Companies, 2004
 Case II - Example
Unlevered Firm Levered Firm

PBIT 5 000 5 000

Interest 0 500

Profit before 5 000 4 500

Tax
Taxes (34%) 1 700 1 530

Net Profit 3 300 2 970

CFFA 3 300 3 470

36 © The McGraw-Hill Companies, 2004

 Interest Tax Shield
• Annual interest tax shield
– Tax rate times interest payment
– 6250 in 8% debt = 500 in interest expense
– Annual tax shield = 0,34(500) = 170
• Present value of annual interest tax shield
– Assume perpetual debt for simplicity
– PV = 170 / 0,08 = 2 125
– PV = D(RD)(TC) / RD = DTC = 6250(0,34) = 2
125

37 © The McGraw-Hill Companies, 2004

 MM Proposition I with Corporate
taxes
• In the presence of corporate taxes, the value of a
levered company will be higher than the value of
otherwise identical unlevered company by the
present value of the interest tax shield
• The value of the levered firm increases by the
Present value of the annual interest tax shield
– Value of a levered firm = value of an unlevered
firm + PV of interest tax shield
• Assuming perpetual cash flows
– VU = PBIT(1-TC) / RU
– VL = VU + DTC
– Value of the firm = Value of equity + Value of
debt
– Maximum firm value is reached at 100% debt!
38 © The McGraw-Hill Companies, 2004
 MM Proposition I with Corporate
taxes
(cont’d)
PBIT( 1  T
C) T
C RD D
VL  
RU RD
VL = VU + TCD
where:
D = market value of debt

RU = unlevered firm’ overall cost of capital (if a firm does

not have debt, it is equal to the cost of unlevered
equity)

RD = cost of debt

PBIT(1- TC )= unlevered firm’s cash flow after corporate tax (TC)

TC RD D = annual tax saving on interest payments (interest tax

shield)

39 © The McGraw-Hill Companies, 2004

MM Proposition I with Corporate taxes Example II
• Data
– PBIT = 1000; Tax rate = 30%; Cost of debt = 8%;
Unlevered cost of capital = 10% debt =1000
VU = PBIT(1-T) / RU
= 1000(1-0,3) / 0,10 = R7000

PBIT( 1  T
C) T
C RD D
VL  
RU RD
VL = 1000(1-0,3) / 0,10 + 1000(0,3)(0.08) /
0.08
= 7 300
What is the value of Equity in the firm VL?
Value of the firm = Value of equity + Value of debt
E = V - D
E = R7300 – 1000 = 40 R6300
© The McGraw-Hill Companies, 2004
MM Proposition I with Corporate
taxes

41 © The McGraw-Hill Companies, 2004

 MM Proposition I with Corporate
taxes Example III
• Data
– PBIT = 25 million; Tax rate = 35%; Debt =
R75 million; Cost of debt = 9%; Unlevered
cost of capital = 12%
• VU = 25(1-0,35) / 0,12 = R135,42
million
• VL = 135,42 + 75(0,35) = R161,67
million
• E = 161,67 – 75 = R86,67 million
42 © The McGraw-Hill Companies, 2004
 MM Proposition II with corporate
taxes
• The WACC decreases as D/E increases
because of the government subsidy on
interest payments
– RA = (E/V)RE + (D/V)(RD)(1-TC)
– RE = RU + (RU – RD)(D/E)(1-TC)

• Example I
– RE = 0,12 + (0,12-0,09)(75/86,67)(1-0,35) =
13,69%
– RA = (86,67/161,67)(0,1369) + (75/161,67)
(0,09)
(1-.35)
RA = 10,05% 43 © The McGraw-Hill Companies, 2004
 Example II

• Suppose that the firm changes its

capital structure so that the debt-to-
equity ratio becomes 1.
• What will happen to the cost of equity
under the new capital structure?
– RE = 0,12 + (0,12 – 0,09)(1)(1-0,35) =
13,95%
• What will happen to the weighted
average cost of capital?
– RA = 0,5(0,1395) + 0,5(0,09)(1-0,35) =
9,9%
44 © The McGraw-Hill Companies, 2004
 Example III (cont’d)
WACC and the cost of equity (MM Proposition II with taxes)
With taxes:
RE = R U + (R U - R D) x (D/E) x (1 - TC )
RE = 0.10 + (0.1- 0.08) x (1000/6300) x (1 - 0.30)
= 10.22%

WACC = (6300/7300) x 0.1022 + (1000/7 300) x 0.08

x (1-.30)
= 9.6%

() The WACC decreases as more debt financing is

used. Optimal capital structure is all debt!

45 © The McGraw-Hill Companies, 2004

MM Proposition II with corporate
taxes

46 © The McGraw-Hill Companies, 2004

 MM Proposition II with corporate
taxes
The implication is that the firm’s
weighted average cost of capital will
decrease as leverage increases. The
benefits of cheaper debt still perfectly
offset the increase in the required return
on equity, but the company realises the
additional benefit of the tax shield on
interest payments.

47 © The McGraw-Hill Companies, 2004

 MM Proposition III
• Assumptions
– Corporate taxes, but no personal taxes
– Insolvency costs
• Now we add insolvency costs
• As the D/E ratio increases, the probability of insolvency
increases
• This increased probability will increase the expected
insolvency costs
• At some point, the additional value of the interest tax
shield will be offset by the expected insolvency cost
• At this point, the value of the firm will start to decrease
and the WACC will start to increase as more debt is
added

48 © The McGraw-Hill Companies, 2004

 Financial distress costs

• Direct costs
– Legal and administrative costs
– Ultimately cause bondholders to incur
additional losses
– Disincentive to debt financing
• Financial distress
– Significant problems in meeting debt
obligations
– Most firms that experience financial distress
do not ultimately file for insolvency
49 © The McGraw-Hill Companies, 2004
 More Insolvency Costs
• Indirect insolvency costs
– Larger than direct costs, but more difficult
to measure and estimate
– Shareholders wish to avoid a formal
insolvency filing
– Bondholders want to keep existing assets
intact so they can at least receive that
money
– Assets lose value as management spends
time worrying about avoiding insolvency
instead of running the business
– Also have lost sales, interrupted operations
and loss of valuable employees
50© The McGraw-Hill Companies, 2004
MM with Financial Distress Costs

51 © The McGraw-Hill Companies, 2004

The Optimal Capital Structure and
the Cost of Capital

52 © The McGraw-Hill Companies, 2004

 Conclusions
• Case I – no taxes or insolvency costs
– No optimal capital structure
• Case II – corporate taxes but no insolvency costs
– Optimal capital structure is 100% debt
– Each additional rand of debt increases the cash flow
of the firm
• Case III – corporate taxes and insolvency costs
– Optimal capital structure is part debt and part
equity
– Occurs where the benefit from an additional rand of
debt is just offset by the increase in expected
insolvency costs

53 © The McGraw-Hill Companies, 2004

 Managerial Recommendations
• The tax benefit is only important if the
firm has a large tax liability
• Risk of financial distress
– The greater the risk of financial distress, the
less debt will be optimal for the firm
– The cost of financial distress varies across
firms and industries and as a manager you
need to understand the cost for your
industry

55 © The McGraw-Hill Companies, 2004

The extended pie model

56 © The McGraw-Hill Companies, 2004

 The Value of the Firm
• Value of the firm = marketed claims + non-
marketed claims
• Marketed claims are the claims of shareholders
and bondholders
• Non-marketed claims are the claims of the
government and other potential stakeholders
• The overall value of the firm is unaffected by
changes in capital structure
• The division of value between marketed claims
and non-marketed claims may be impacted by
capital structure decisions

57 © The McGraw-Hill Companies, 2004

 The Pecking-Order
Theory
• The Pecking Order Hypothesis predicts that if
external financing is required, firms will choose to
issue the safest or cheapest security first,
starting with debt financing and using equity as a
last resort.
• Asymmetric information means that managers or
owners of a company know more about the future
performance of the company than potential
outside lenders.
– External lenders generally require the company to
provide private information about the company, its
plans, current operations, and past performance.
– If information is proprietary and the company feels that
it could be helpful to a competitor if it was to become
public knowledge through lending,© then the company’s
The McGraw-Hill Companies, 2004
 The Pecking-Order Theory
• Theory stating that firms prefer to issue debt
rather than equity if internal financing is
insufficient.
– Rule 1
• Use internal financing first
– Rule 2
• Issue debt next, new equity last
• The pecking-order theory is at odds with the
tradeoff theory:
– There is no target D/E ratio
– Profitable firms use less debt
– Companies like financial slack
59 © The McGraw-Hill Companies, 2004
 The Pecking-Order Theory
• There are three implications of the
POH.
– LESS profitable companies will need more
external funding and will first seek debt
financing in an asymmetric world, avoiding the
equity market.
– Profitable companies will borrow less (because
they have more internal funds available) and
may have lower debt-equity ratios because
they have more debt capacity.
– As a last resort, firms will sell equity to fund
investment opportunities.
© The McGraw-Hill Companies, 2004
 Observed Capital Structure

• Capital structure does differ by industry

• Differences according to Cost of Capital
2008 Yearbook by Ibbotson Associates,
Inc.
– Lowest levels of debt
• Computers with 5,61% debt
• Drugs with 7,25% debt
– Highest levels of debt
• Cable television with 162,03% debt
• Airlines with 129,40% debt

61 © The McGraw-Hill Companies, 2004

 Evidence on Capital Structure
• More profitable firms tend to use less
leverage.
• High-growth firms borrow less than
mature firms do.
• Firms’ product market strategies and
asset bases influence their capital
structure choices.
• Shares market generally views
leverage-increasing events positively.
• Tax deductibility of interest gives firms
an incentive to use debt. 62 © The McGraw-Hill Companies, 2004
 More evidence on Capital Structure

Capital structures vary across firms,

industries, and countries.
Modigliani and Miller showed that in a
world of frictionless capital markets
capital structure is irrelevant.
Personal taxes on debt, bankruptcy
costs, agency costs, and asymmetric
information influence level of debt the
firm chooses to have.
© The McGraw-Hill Companies, 2004
Capital Structure in Practice

64 © The McGraw-Hill Companies, 2004

 Comprehensive Problem

• Assuming perpetual cash flows in Case

II Proposition I, what is the value of
equity for a firm with EBIT = R50
million, Tax rate = 40%, Debt = R100
million, cost of debt = 9%, and
unlevered cost of capital = 12%?

65 © The McGraw-Hill Companies, 2004