Capital Structure Part 1

Example
You are considering an investment
opportunity. The project will generate cash
flows of either $1,400 or $900 next year,
depending on whether the economy is strong
or weak, respectively. Both scenarios are
equally likely
Date 1 Date 1 Date 0
Strong Weak Expected Present
economy economy value value
Cash-flows
Firm $1,400 $900 $1,150

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Cost of capital – all equity financing
You finance the project by issuing equity only

The project cash flows depend on the overall

economy and thus contain market risk. As a
result, you demand a 10% risk premium over
the current risk-free interest rate of 5% to
invest in this project

Cost of capital = 5% + 10% = 15%

PV of the project
Expected cash-flow

Date 1 Date 1 Date 0

Strong Weak Expected Present
economy economy value value
Cash-flows
Firm $1,400 $900 $1,150 $1,000

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Equity/Firm value
If you finance the project by raising equity,
you can raise $1,000 because this is what the
equity-holders would be willing to pay based
on the project’s cash-flows and risk

Value of firm, VU = Value of assets, A

= Value of equity, E = $1,000

Since the firm has no debt, the equity in this

firm is referred to as unlevered equity

Expected return
Shareholder’s returns are either 40% or
−10% and the expected return is 15%

Date 1 Date 1 Date 0

Strong Weak Expected Present
economy economy value value
Cash-flows
Unlev equity $1,400 $900 $1,150 $1,000
Return
Unlev equity 40% -10% 15%

Because the cost of capital of the project is

15%, shareholders are earning an
appropriate return for the risk they are taking
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Levering up
You decide to borrow $500 initially, in
addition to selling equity. Because the
project’s cash flow will always be enough to
repay the debt, the debt is risk free and you
can borrow at the risk-free interest rate of
5%. You will owe the debt holders $500×1.05
= $525 in one year. The equity in a firm that
also has debt outstanding is now ‘levered
equity’

How much is the firm worth?

How much is the levered equity worth?
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Cash-flows in the levered firm

Date 1 Date 1 Date 0

Strong Weak Expected Present
economy economy value value
Cash-flows
Firm $1,400 $900 $1,150 ??
Debt $525 $525 $525 $500
Lev equity $875 $375 $625 ??

Is the firm still worth $1,000?

Is the equity worth

• $500 = $1,000(Old unlevered firm)−$500(Debt)
• $543 = $625/(1+15%)
• something else? 8
Modigliani Miller (MM)
MM argued that with perfect capital markets,
the total value of a firm should not depend on
its capital structure
• Firm’s total cash flows still equal the cash flows
of the project, and therefore have the same
present value  Firm value remains $1,000

Date 1 Date 1 Date 0

Strong Weak Expected Present
economy economy value value
Cash-flows
Firm $1,400 $900 $1,150 $1,000
Debt $525 $525 $525 $500
Lev equity $875 $375 $625 ??
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MM …
Because the cash-flows of the debt and
equity sum to the cash-flows of the project,
the combined values of debt and equity must
be $1,000

Value of the levered equity must be $500

Date 1 Date 1 Date 0
Strong Weak Expected Present
economy economy value value
Cash-flows
Firm $1,400 $900 $1,150 $1,000
Debt $525 $525 $525 $500
Lev equity $875 $375 $625 $500
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Leverage and return

Date 1 Date 1 Date 0

Strong Weak Expected Present
economy economy value value
Cash-flows
Firm $1,400 $900 $1,150 $1,000
Debt $525 $525 $525 $500
Lev equity $875 $375 $625 $500
Return
Firm 40% -10% 15%
Debt 5% 5% 5%
Lev equity 75% -25% 25%

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Leverage and risk

Leverage increases the risk of the equity of a
firm

It is inappropriate to discount the cash flows

of levered equity at the same discount rate of
15% that you used for unlevered equity

Investors in levered equity will require a

higher expected return to compensate for the
increased risk

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Leverage and risk and return
Leverage increases the risk of equity even
when there is no risk that the firm will default

While debt may be cheaper, its use raises the

cost of capital for equity

Considering both sources of capital together,

the firm’s average cost of capital with
leverage is the same as for the unlevered
firm

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What if MM fails?
What if the levered equity were selling for
$490?
Arbitrage: Buy the firm (debt + equity) for
$990. Resell for $1,000

What if the levered equity were selling for

$510?
Arbitrage: Sell the firm (debt + equity) for
$1,100. Buy back for $1,000

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Quiz 1 (easy)
If the entrepreneur borrows only $200 in
debt, what is the value of equity and its
expected return?
Date 1 Date 1 Date 0
Strong Weak Expected Present
economy economy value value
Cash-flows
Firm $1,400 $900 $1,150 $1,000
Debt $210 $210 $210 $200
Lev equity $1,190 $690 $940 $800
Return
Firm 40% -10% 15%
Debt 5% 5% 5%
Lev equity 49% -14% 18%
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Quiz 2 (easy)
If the entrepreneur borrows $700 in debt,
what is the value of equity and its expected
return?
Date 1 Date 1 Date 0
Strong Weak Expected Present
economy economy value value
Cash-flows
Firm $1,400 $900 $1,150 $1,000
Debt $735 $735 $735 $700
Lev equity $665 $165 $415 $300
Return
Firm 40% -10% 15%
Debt 5% 5% 5%
Lev equity 122% -45% 38%
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Quiz 3 (hard)
If the entrepreneur borrows $900 in debt,
what is the value of equity and its expected
return?

 Now the debt is risky too

 Debtholders demand a (promised) return of
16⅔% (why 16⅔%? Trust me!)
 Promised debt repayment =
$900×(1+16⅔%) = $1,050 in one year
• In case of weak economy, can’t pay back the
entire sum

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Quiz 3 …
Date 1 Date 1 Date 0
Strong Weak Expected Present
economy economy value value
Cash-flows
Firm $1,400 $900 $1,150 $1,000
Debt $1,050 $900 $975 $900
Lev equity $350 $0 $175 $100
Return
Firm 40% -10% 15%
Debt 17% 0% 8%
Lev equity 250% -100% 75%
 Expected return on debt = 8⅓%
• Promised return is 16⅔%
 Expected return on equity = 75%
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Different debt ratios
Debt Equity Firm
Value - $1,000 $1,000
1.
E(Return) - 15% 15%

Value $200 $800 $1,000

2.
E(Return) 5% 18% 15%

Value $500 $500 $1,000

3.
E(Return) 5% 25% 15%

Value $700 $300 $1,000

4.
E(Return) 5% 38% 15%

Value $900 $100 $1,000

5.
E(Return) 8% 75% 15%
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Different debt ratios …

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Different debt ratios …

With more realistic normally distributed payoffs

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Market value balance sheet

Debt = D
(RD)

Assets = A
(RA)
Equity = E
(RE)

A=D+E
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MM and cost of capital
(Expected) Return on assets is a weighted
average of the return on debt and return on
equity

Verify: With D = E = $500

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MM and leverage
Levered equity is riskier and has higher
return than unlevered equity

Verify: With D = E = $500

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MM and WACC
We can also call return on assets as WACC
(weighted average cost of capital). Thus, in
absence of taxes

With perfect capital markets, a firm’s WACC

is independent of its capital structure

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Example
Honeywell International Inc. (HON) has a
market debt-equity ratio of 0.5

Assume its current debt cost of capital is

6.5%, and its equity cost of capital is 14%

If HON issues equity and uses the proceeds

to repay its debt and reduce its debt-equity
ratio to 0.4, it will lower its debt cost of
capital to 5.75%

What is the new equity cost of capital?

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Example …
Current WACC

New equity cost

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Capital structure fallacies

1. Leverage increases EPS  Leverage is
good for stock price

2. Issuing equity leads to dilution of equity

ownership  Debt financing should be
preferred

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Leverage and EPS (1)
Consider Levitron Industries, LVI
 No debt
 EBIT of $10 million
 10 million shares
 Price of share is $7.5
 No growth

EPS = $10m/10m = $1
Market value = $7.5×10m = $75m
Cost of equity = $1/$7.5 = 13.33%
• Gordon growth formula with no growth
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Leverage and EPS (2)

LVI wants to borrow $15m at an interest rate
of 8%
• The proceeds will be used to repurchase 2 million
shares at $7.5/share

 New interest = $15m×8% = $1.2m

 New earnings = $10m−$1.2m = $8.8m
 New EPS = $8.8m/8m = $1.1
 New equity value = $60m

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Leverage and EPS (3)
Stock price stays the same!
• Although expected EPS rises with leverage, the
risk of its EPS also increases
• Necessary to compensate shareholders for the
additional risk they are taking

New cost of equity = $1.1/$7.5 = 14.66%, or

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Leverage and dilution (1)

Consider Jet Sky Airlines, JSA
 No debt
 500 million shares
 Price of share is $16

Market value = $16×500m = $8b

If JSA needs additional $1b for expansion,

should it issue equity?

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Leverage and dilution (2)
To raise $1b, JSA can issue 62.5m shares at
$16/share

 New #shares = 500+62.5 = 562.5m

 New market value = $8b+$1b = $9b
 New price = $9b/562.5m = $16

As long as the firm sells the new shares of

equity at a fair price, there will be no gain or
loss to shareholders associated with the
equity issue itself
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To remember
MM theorem: In a perfect capital market, the
total value of a firm is equal to the market
value of the total cash flows generated by its
assets and is not affected by its choice of
capital structure

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