Capital Structure in Perfect Markets: Additional Handout

Consider the project we looked at in class: spend 800 now to get cash flows of 1400
or 900 in one year with equal probabilities.

Given some rate rU (that corresponds to the rate of return that our investors require
to invest in a project of this riskiness), the NPV of this project is:
-800+(0.5*1400+0.5*900)/(1+rU). (in class: rU=15%, so NPV=200)

If the entrepreneur does not have the money, then to do the project and pocket NPV,
he must raise 800+NPV.

Case 1: finance by unlevered equity, i.e. raise 800+NPV today by selling rights to all
future project cash flows.

Our equity holders also require rU (the riskiness of the project cash flows is still the
same), so they value project cash flows at (0.5*1400+0.5*900)/(1+rU) which is
800+NPV.

Assumptions of the perfect market in MM basically imply that the NPV of all financial
transactions is 0 (i.e. we raised equity at “fair” terms); the proof itself comes from the
arbitrage argument we discussed in class.

Case 2a: finance by both debt and equity, i.e. raise D in debt and the rest
(E=800+NPV-D) in equity. (in class D=500, so E=500)

Assume now for simplicity that debt is riskless, i.e. cash flows are always above what
is required to repay to debt holders.

Debt cash flows in one year are D(1+rD), where rD is the required return on debt
(in class 5%, so D(1+rD)=525).

Again, assumptions of the perfect market imply that we raise debt at “fair” terms:
D = D(1+rD)/(1+rD).

Equity cash flows in one year are 1400-D(1+rD) or 900-D(1+rD) with equal
probabilities.
Question: at which rate rE does the present value of these cash flows amount to
800+NPV-D? (I.e. at which rate will raising equity be a zero-NPV transaction).

(and that’s our MM2).

Another version of the same derivation:

If amount raised today by a combo of debt and equity is D+E = 800+NPV,

while amount raised by unlevered equity is U = 800+NPV,
Then the total cash flows in one period are D(1+rD)+ E(1+rE) =0.5*1400+0.5*900,
while for unlevered equity U(1+rU) =0.5*1400+0.5*900.

Plug in U=D+E into D(1+rD)+ E(1+rE)= U(1+rU) to derive MM2.

Case 2b: finance by risky debt and equity (i.e. now D(1+r) >900 and with probability
0.5 cash flows are not enough to repay principal and interest, so debt holders own
the firm and get the rights on the cash flow).

Debt cash flows in one year are D(1+r) or 900 with equal probabilities, where r here is
some promised return to debt holders.

Again, assumptions of the perfect market imply that we raise debt at “fair” terms:
D = (0.5*D(1+r)+0.5*900)/(1+rD).

Equity cash flows in one year are 1400-D(1+r) or 0 with equal probabilities.
Raised at fair terms: E = (0.5*(1400-D(1+r))+0.5*0)/(1+rE).

Again, the sum of period 1 cash flows of debt holders and equity holders amounts to:
D(1+rD)+ E(1+rE) = (0.5*D(1+r)+0.5*900) + (0.5*(1400-D(1+r)+0.5*0)=
0.5*1400+0.5*900= U(1+rU) as before.

So the formula for rE (MM2) will be the same, although numerically it will be another
number since rD has increased and proportion of debt has increased.

Case 3: Suppose entrepreneur has some amount X to finance the project, but not
enough. Then he raises 800+NPV-X externally. We can consider different scenarios
again, but let’s focus on raising outside equity only (you can try different
combinations of internal funds/debt/outside equity on your own).

Question: which share of total equity () do we need to offer in order to raise
800+NPV-X (i.e. which share of future cash flows should go to our outside equity
holders, so that this transaction is zero-NPV)?

(Summing the two equations checks that entrepreneur and outside equity holder
receive in total future cash flows).
Divide one by another to see that , i.e. sell the share proportional to
the amount raised.