RSM433 - Advanced Corporate Finance

Session 1
MODULE 1: CAPITAL STRUCTURE
CAPITAL STRUCTURE IN PERFECT MARKETS

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Road Map
1. Capital Structure in Perfect Markets ◄ we are here
1. The Value of an Asset
2. Conservation of Value Principle
3. Modigliani-Miller 1: Leverage and Firm Value
4. Conservation of Risk and Modigliani and Miller 2
5. Capital Structure Fallacies

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1. THE VALUE OF AN ASSET
Motivation: Numerical Example
• Consider the opportunity of starting a flower shop:

 The project generates cash flows of either $1400 or $900

next year, depending on whether the economy is strong
or weak, respectively

 Both scenarios are equally likely

$1400
p=1/2

p=1/2
$900
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Numerical Example: Equity Financing

$1400
p=1/2

p=1/2
$900

• The project cash flows depend on the overall

economy and thus contain market risk
• As a result, equity investors demand a 10% risk
premium over the current risk-free interest rate of
5% to invest in this project
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Question 1
• What is the market value of the project/asset?

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How to Measure Value?
• In finance, we measure the value of not only a
business or an investment project, but also of a
security as the Net Present Value of the future
cashflows

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Question 1
• What is the market value of the project/asset?
• Solution:
• Present Value of Future Cash Flows generated by
the investment = [1400(.5)+900(.5)]/1.15 = 1000

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2. CONSERVATION OF VALUE
PRINCIPLE
Unlevered Equity: Definition
• Definition: Equity in a firm with no debt

• Because there is no debt, the cash flows of the

unlevered equity are equal to those of the project

$1400.
p=1/2 Return=40%

p=1/2 $900
Return=-10%
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Debt Borrowing
• Suppose Lisa decides 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
Lisa can borrow at the risk-free interest rate of 5%.
• Lisa will owe the debt holders:
 $500 × 1.05 = $525 in one year

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Levered Equity
• Definition: Equity in a firm that also has debt
outstanding

• What is the market value of the levered equity?

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Modigliani-Miller I
• The cash flows paid to shareholders and debtholders
are the cash flows generated by the firm

• By the Law of One Price the combined values of

debt and equity must be equal to the value of the
firm (=$1000).

• Therefore, if the value of the debt is $500, the value

of the levered equity must be $500.
 E = $1000 – $500 = $500

• Because the cash flows of levered equity

are smaller than those of unlevered equity, levered
equity sells for a lower price ($500 versus $1000) 13
3. MODIGLIANI AND MILLER 1
Value Creation versus Value Distribution
• First order effect of investment decisions: value
creation
 Objective: select positive NPV projects that increase the
value of the firm

• BUT First order effect of financing decisions: value

distribution
 Objective: decide how to distribute the value of the firm
among investors

 Financing decisions do not (directly) create value,

they affect how this value is shared 15
 Capital structure - Definition
 Definition: Capital Structure is the mix of debt and equity that a
firm uses to fund its operations

Equity Value
Operational (e.g. $50M)
Firm Value Capital Structure
Performance (ROI)
Debt Value
(e.g. $10M)

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Question: In perfect capital markets…

• Can we find a mix of debt and equity that maximizes

the firm value?

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Modigliani-Miller I (AER, 1958)
• With perfect capital markets, the total value of a
firm should not depend on its capital structure.

1985 18
Effect of Leverage on Risk and Return
• Why the market value of equity is not just the future
cash flows discounted at 15%?

 Leverage increases the risk of the equity of a firm

 Investors require a higher expected return to compensate

for the increased risk

• What is the new expected return for equity holders?

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Effect of Leverage on Risk and Return
• The returns to equity holders are different with and
without leverage.

 Unlevered equity has a return of either 40% or –10%, for

an expected return of 15%

 Levered equity has higher risk, with a return of either 75%

or –25%
 To compensate for this risk, levered equity holders
receive a higher expected return of 25%

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3. MODIGLIANI-MILLER 1: LEVERAGE
AND FIRM VALUE
Intuition
• Look at this pizza ….

• Can you find a way to cut the pizza that increases

the size of the pizza?

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Intuition
• Of course not ! … The way you cut the pizza does
not affect the size of the pizza
• Similarly, the way the firm is financed (debt or
equity) does not affect the firm value
• That’s exactly the Irrelevance Theorem of
Modigliani and Miller :
• In a perfect world, the capital structure is irrelevant.
I.e. the value of the firm is not affected by the
manner in which it is financed!

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MM Proposition I
• 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

 The total value of a firm is NOT affected by its

choice of capital structure.

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What is a Perfect World?
1. No taxes
2. No transaction costs
3. Perfect Information
• Implications:
 Firms and investors can borrow/lend at the same rate
 Firms in distress can be reorganized without cost
 Managers act in shareholders’ interests

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Proof
• In the absence of taxes or other transaction costs,
the total cash flow paid out to all security holders is
equal to the total cash flow generated by the firm’s
assets
• Therefore, by the Law of One Price, the firm’s
securities and its assets must have the same total
market value
• Thus, as long as the firm’s choice of securities does
not change the cash flows generated by its assets,
this decision will not change the total value of the
firm
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Implications
• The value of a firm is independent of its capital
structure:
VL= VU =E+ Net Debt
• Net Debt= Debt - Cash

 For firms with cash, value is the market capitalization

minus the cash
 E?

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Implications: Firm with Positive Cash
• The value of a firm with Cash is lower than the value
of Equity!

Firm Value = Equity - Cash

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Why Understanding MM is important?
• MM is not a literal statement about the real world
• But all scientific theories begin with a set of ideal
assumptions from which conclusions can be drawn
• What matters is to evaluate precisely which
assumptions hold or do not hold to consider the
consequences
• It helps you think about the right question:
 What market imperfection does this financing decision
address?

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Problem 1.2

• Suppose Lisa borrows only $200 when financing the

project. According to Modigliani and Miller, what
should the value of equity be?

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Problem 1.2 - Solution
• VL= VU =E+ Net Debt
• VU = 1000
• Net Debt = 200
• E = 800

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32
4. CONSERVATION OF RISK
Conservation of Risk Principle

 With perfect capital markets, financial transactions neither add

nor destroy value, but instead represent a repackaging of risk
(and therefore return).

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Introduction to MM Proposition II
• In perfect capital markets, the value of the firm does
not vary with leverage

• Cash flows are the same, the discount rate is the

same

=> the cost of capital does not vary with leverage

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Introduction to MM Proposition II

WACC

D
Market Leverage Ratio
V 36
Introduction to MM Proposition II
• Debt is senior to equity: equity holders are the
residual claimants on cash flows

• When leverage increases, the volatility of cash flows

to equity holders increases

=> the cost of equity increases with leverage

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 Introduction to MM Proposition II
Re

RA
RD

Rf

D
Market Leverage Ratio
V 38
Introduction to MM Proposition II
• Debt is a safe asset as soon as the firm can pay
interest payments in all states of the world

• When leverage increases a lot, debt becomes risky

• Debt in a firm with zero equity offers the same cash

flows (with the same risk) as equity in an unlevered
firm

=> the cost of debt increases with leverage only

beyond a certain level of risk

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 Introduction to MM Proposition II
Re

RA
RD

Rf

D
Market Leverage Ratio
V 40
MM Proposition II

• The cost of capital of levered equity is equal to the

cost of capital of unlevered equity plus a premium
that is proportional to leverage (ratio of debt over
(debt + market value or equity)

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5. CAPITAL STRUCTURE FALLACIES
 #1: Debt is Cheap
• Because debt is safer than equity, investors demand a
lower return for holding debt than for holding equity
(True or False?)

• So, companies should always finance themselves with

debt because they have to give away less returns to
investors, i.e., debt is cheaper (True or False?)

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 #1: Debt is Cheap
• Because debt is safer than equity, investors demand a
lower return for holding debt than for holding equity
(True)

• So, companies should always finance themselves with

debt because they have to give away less returns to
investors, i.e., debt is cheaper (False)

• This reasoning ignores the “hidden” cost of debt:

 Raising more debt makes existing equity more risky
 This is unrelated to default risk and also true when debt is
risk-free
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#2: Leveraged Buybacks
• In perfect markets, leverage buybacks increase value to
shareholders (True or False?)
• In perfect markets, leverage buybacks increase the cost of
equity (True or False?)

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#2: Leveraged Buybacks
• In perfect markets, leverage buybacks increase value to
shareholders? False
• In perfect markets, leverage buybacks increase the cost of
equity? True

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Take Away
• In a perfect markets, capital structure has no impact
on firm value!
• In other words, you cannot distribute more value to
shareholders by changing the capital structure
• Leverage increases the cost of equity

 If a hedge fund pitches you about financing

decisions that would impact firm value, think twice
and investigate carefully! (which imperfection?)

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