480 Chapter 14 Capital Structure in a Perfect Market

TABLE 14.2 Cash Flows and Retums tor Unlevered Equity

Date O Date 1: Cash Flows Date 1: Returns

Inicial Value Strong Economy Weak Economy Strong Economy Weak Econorny
Unlevered equity $1000 $1400 $900 40% -10%

Equity in a firrn with no debt is called unlevered equity. Because there is no deb~
the date 1 cash flows of the unlevered equity are equal to those of the project. Giveo
equity's initial value of $1000, shareholders' returns are either 40% or -10%, as shownin
Table 14.2.
The strong and weak economy outcomes are equally likely, so the expected returnon
! !
the unlevered equity is (40%) + (-10%) = 15%. Because the risk of unlevered equi~
equals the risk of the project, shareholders are earning an appropriate return for therisk
they are taking.

Financing a Firm with Debt and Equity

Financing the firrn exclusively with equity is not the entrepreneur' s only option. Shecan
also raise part of the initial capital using debt. Suppose she decides to borrow $500ini-
tially, in addition to selling equity. Because the project's cash flow will always be enough»
repay rhe debt, the debt is risk free. Thus, the firrn can borrow at the risk-free interestfare
of 5%, and it will owe the debt holders 500 x 1.05 = $525 in one year.
Equity in a firrn that also has debt outstanding is called levered equity. Promiscd
payments to debt holders must be made before any payments to equity holders aredis-
tributed. Given the firrn's $525 debt obligation, the shareholders will receiveonly
$1400 - $525 = $875 if the economy is strong and $900 - $525 = $375 if the econom,
is weak. Table 14,3 shows the cash flows of rhe debt, the levered equity, and the totalcasb
flows of the firmo
What price E should the levered equity sell for, and which is the besr capital strucne
choice for the entrepreneur? In an important paper, researchers Franco Modiglianiand
Merton Miller proposed an answer to this question that surprised researchers and practi-
tioners at the time.' They argued that with perfect capital markets, the total valueorl
firrn should not depend on its capital structure. Their reasoning: The firm's total cashflolll

TABLE 14.3 Values and Cash Flows tor Debt and Equity
of the Levered Firm

Date O Date 1: Cash Flows

Initial Value Strong Economy Weak Econorny
Debr $500 $525 $525
Levered equity E=? $875 $375
Firm $1000 $1400 $900

F. Modigliani and M. Miller, "The Cost of Capital, Corporation Finance and the Theory of Investmea
¡

American Economic Review 48(3) (1958): 261-297.