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Capital Structure: Debt Versus Equity
Capital Structure: Debt Versus Equity
D E
rA = × rD + × rE
D+E D+E
M&M Proposition II
r
rE
rA
rD
D
Risk free debt Risky debt E
M&M Proposition 2
• Bonds are almost risk-free at low debt levels
– rD is independent of leverage
– rE increases linearly with debt-equity ratios and the
increase in expected return reflects increased risk
• As firms borrow more, the risk of default rises
– rD starts to increase
– rE increases more slowly (because the holders of risky
debt bear some of the firm’s business risk)
The Return on Equity
• The increase in expected equity return
reflects increased risk
• The increase in leverage increases the
amplitude of variation in cash flows
available to share-holders (the same
change in operating income is now
distributed among fewer shares)
• We can understand the increase in risk in
terms of Betas
Leverage and Returns
D E
BA = × BD + × BE
D+E D+E
D
BE = BA + ( BA − BD )
E
The Traditional Position
• What did financial experts think before
M&M?
• They used the concept of WACC
(weighted average cost of capital)
– WACC is the expected return on the portfolio
of all the company’s securities
WACC
WACC is the traditional view of capital
structure, risk and return.
D E
WACC = rA = × rD + × rE
V V
WACC
Expected
Return
.20=rE
Equity
.15=rA
All
assets
.10=rD
Debt
Risk
BD BA BE
WACC
Example - A firm has $2 mil of debt and
100,000 of outstanding shares at $30
each. If they can borrow at 8% and the
stockholders require 15% return what is
the firm’s WACC?
D = $2 million
E = 100,000 shares X $30 per share = $3 million
V = D + E = 2 + 3 = $5 million
WACC
Example - A firm has $2 mil of debt and 100,000 of
outstanding shares at $30 each. If they can borrow at
8% and the stockholders require 15% return what is the
firm’s WACC? D = $2 million
E = 100,000 shares X $30 per share = $3 million
V = D + E = 2 + 3 = $5 million
D E
WACC = × rD + × rE
V V
2 3
= × .08 + × .15
5 5
= .122 or 12.2%
The Traditional Position
• The return on equity (rE) is constant
• WACC declines with increasing leverage
because rD<rE
• Given the two assumptions above, a firm
will minimize the cost of capital by issuing
almost 100% debt
• This can’t be correct!
WACC (if rE does not change with
increases in leverage )
r
rE
rA =WACC
rD
D
V
An intermediate position
• A moderate degree of financial leverage may
increase the return on equity (but less than
predicted by M&M proposition 2)
• A high degree of financial leverage increases the
return on equity (but by more than predicted by
M&M proposition 2)
• WACC then declines at first, then rises with
increasing leverage (U-shape)
• Its minimum point is the point of “optimal capital
structure”.
WACC (intermediate view)
r
rE
WACC
rD
D
E
The intermediate position
• Investors don’t notice risk of “moderate” borrowing
• They wake up with debt is “excessive”
• The problem with this view is that it confuses default
risk with financial risk.
– Default risk may not be serious for moderate amounts of
leverage
– Financial risk (in terms of increased volatility of return and
higher beta) will increase with leverage even with no risk
of default
Modigliani and Miller Revisited
• M&M proposition 1: A firm’s total value is
independent of its capital structure
• Assumptions needed for Prop 1 to hold:
1. Capital markets are perfect and complete
2. Before-tax operating profits are not affected by
capital structure
3. Corporate and personal taxes are not affected by
capital structure
4. The firm’s choice of capital structure does not
convey important information to the market
Modigliani and Miller Revisited
• M&M Proposition 2: The return on equity
will rise as the debt-equity ratio rises in
order to compensate equity holders for the
additional (financial) risk.
• Note: Proposition 2 does not rely on
default risk – rE rises because of the rise in
financial risk
WACC (M&M view)
r
rE
WACC
rD
D
E
Capital Structure and Corporate
Taxes
Financial Risk - Risk to shareholders resulting
from the use of debt.
Financial Leverage - Increase in the variability of
shareholder returns that comes from the use of
debt.
Interest Tax Shield- Tax savings resulting from
deductibility of interest payments.
Capital Structure and Corporate
Taxes
Example - You own all the equity in a company. The
company has no debt. The company’s annual cash
flow is $1,000, before interest and taxes. The
corporate tax rate is 40%. You have the option to
exchange 1/2 of your equity position for 10% bonds
with a face value of $1,000.
Example:
Tax benefit = 1000 x (.10) x (.40) = $40
PV of 40 perpetuity = 40 / .10 = $400
Example
All Equity Value = 600 / .10 = 6,000
PV Tax Shield = 400
WACC
rD
D
E
Financial Distress
Maximum value of firm
Costs of
Market Value of The Firm
financial distress
PV of interest
tax shields
Value of levered firm
Value of
unlevered
firm
Optimal amount
of debt
Debt/Total Assets
M&M with taxes and bankruptcy
• WACC now is more hump-shaped (similar
to the traditional view – though for different
reasons).
• The minimum WACC occurs where the
stock price is maximized.
• Thus, the same capital structure that
maximizes stock price also minimizes the
WACC.
Financial Choices
Trade-off Theory - Theory that capital structure is
based on a trade-off between tax savings and
distress costs of debt.
The most profitable firms borrow less not because they have
lower target debt ratios but because they don't need external
finance.
Pecking Order Theory
Some Implications:
Internal equity may be better than external
equity.
Financial slack is valuable.
If external capital is required, debt is better.
(There is less room for difference in opinions
about what debt is worth).