Chapter 16

Capital Structure:
Basic Concepts

McGraw-Hill/Irwin Copyright © 2010 by the McGraw-Hill Companies, Inc. All rights reserved.
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Chapter Outline
❑ The Capital Structure Question and The Pie
Theory
❑ Maximizing Firm Value versus Maximizing
Stockholder Interests
❑ Financial Leverage and Firm Value: An
Example
❑ Modigliani and Miller: Proposition I & II (No
Taxes)
❑ Modigliani and Miller: Proposition I & II (With
Taxes)
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Capital Structure and Pie Theory
 The value of a firm is defined to be the sum of the
value of the firm’s debt and the firm’s equity.
V=B+S
❑ If the goal of the firm’s management is to make the firm
as valuable as possible, then the firm should pick the
debt-equity ratio that makes the pie as big as possible.
B

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Capital Structure Questions
There are two important questions:
❑ Why should the stockholders in the firm care about
maximizing the value of the entire firm?
❑ What ratio of debt to equity maximizes the
shareholders’ interests?

As it turns out, changes in capital structure

benefit the stockholders if and only if the value
of the firm increases.

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Maximizing Firm Value versus
Maximizing Stockholder Interests
❑ 100 shares of stock sells for $10.
❑ Plans to borrow $500 and pay the $500
proceeds to shareholders.

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Maximizing Firm Value versus
Maximizing Stockholder Interests

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Maximizing Firm Value versus
Maximizing Stockholder Interests
Two important questions:
❑ Why should the stockholders in the firm care about
maximizing the value of the entire firm?
❑ Managers should choose the capital structure that they
believe will have the highest firm value because this
capital structure will be most beneficial to the firm’s
stockholders.
❑ ANSWERED.
❑ What ratio of debt to equity maximizes the
shareholders’ interests?

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Financial Leverage and Firm Value
❑ To determine the optimal capital structure –
❑ We need to investigate the effect of capital
structure on returns to stockholders.

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Financial Leverage and Firm Value

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Financial Leverage and Firm Value

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Financial Leverage and Firm Value

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Financial Leverage and Firm Value
❑ Modigliani and Miller (MM or M & M) Proposition I

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Financial Leverage and Firm Value
❑ Trans Am is neither helping nor hurting its
stockholders by restructuring.
❑ Investors are not receiving anything from corporate
leverage that they could not receive on their own.
❑ MM Proposition I (no taxes): The value of the
levered firm is the same as the value of
the unlevered firm.
❑ As long as individuals borrow (and lend) on the
same terms as the firms, they can duplicate the
effects of corporate leverage on their own
(homemade leverage).
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Modigliani and Miller: Proposition
II (No Taxes)

❑ Risk to equity
holders rises
with leverage.

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Modigliani and Miller: Proposition
II (No Taxes)

❑ Risk to equity
holders rises
with leverage.

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Modigliani and Miller: Proposition
II (No Taxes)
❑ MM Proposition II: The expected return on equity
is positively related to leverage because the risk to
equity holders increases with leverage.
❑ 𝑹𝐖𝐀𝐂𝐂 :
𝑆 𝐵
𝑅WACC = × 𝑅𝑠 + × 𝑅𝐵
𝑆+𝐵 𝑆+𝐵
where, S = The value of stock or equity
B = The value of bond or debt
RS = Cost of equity
RB = Cost of debt
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Modigliani and Miller: Proposition
II (No Taxes)
❑ An implication of MM Proposition I is that 𝑹𝑾𝑨𝑪𝑪
is a constant for a given firm, regardless of the
capital structure.

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MM Proposition II (No Taxes)
❑ Cost of capital for an all-equity firm,
Expected earnings to unlevered firm
𝑅0 =
Unlevered equity
$1,200
= = 15%
$8,000
❑ 𝑹𝑾𝑨𝑪𝑪 must always equal 𝑹𝟎 in a world without
corporate taxes.
❑ MM Proposition II (No Taxes)
𝐵
𝑅𝑆 = 𝑅0 + (𝑅0 − 𝑅𝐵 )
𝑆

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MM Proposition II (No Taxes)

❑ 𝑹𝑺 is positively related to the firm’s debt–equity

ratio.
❑ 𝑹𝑾𝑨𝑪𝑪 is invariant to the firm’s debt–equity ratio.
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MM Proposition II (No Taxes)
❑ Modigliani–Miller results indicate that managers
cannot change the firm value by repackaging the
firm’s securities.
❑ MM argue that the firm’s overall cost of capital
cannot be reduced as debt is substituted for
equity, even though debt appears to be cheaper
than equity.
❑ The reason for this is that as the firm adds debt, the
remaining equity becomes more risky.

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MM Proposition II (No Taxes)
❑ As this risk rises, the cost of equity capital rises as
a result.
❑ The increase in the cost of the remaining equity
capital offsets the higher proportion of the firm
financed by low-cost debt.
❑ In fact, MM prove that the two effects exactly offset
each other, so that both the value of the firm and the
firm’s overall cost of capital are invariant to
leverage.

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Summary of MM Propositions without Taxes
❑ Assumptions
❑ No taxes.
❑ No transaction costs.
❑ Individuals and corporations borrow at same rate.
❑ Results
❑ Proposition I: 𝑉𝐿 = 𝑉𝑈
𝐵
❑ Proposition II: 𝑅𝑆 = 𝑅0 + (𝑅0 − 𝑅𝐵 )
𝑆
❑ Intuition
❑ Proposition I: Through homemade leverage individuals
can either duplicate or undo the effects of corporate
leverage.
❑ Proposition II: The cost of equity rises with leverage
because the risk to equity rises with leverage.
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 Important Question

Do real-world managers follow MM by

treating capital structure decisions with
indifference?

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Unrealistic Assumptions
❑ Taxes were ignored.
❑ Bankruptcy costs and other agency costs
were not considered.

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Taxes
❑ In a world without taxes -
❑ Firm value is unrelated to debt.
❑ In the presence of corporate taxes -
❑ The firm’s value is positively related to its debt.

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Present Value of the Tax Shield

❑ Assuming that the cash flow has the same risk as the
interest on the debt and the cash flows are
perpetual, the present value of tax shield:

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Value of the Levered Firm
❑ The value of an unlevered firm:

❑ Leverage increases the value of the firm by

the tax shield.

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Expected Return and Leverage
under Corporate Taxes

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Summary of MM Propositions with Taxes
❑ Assumptions
❑ Corporations are taxed at the rate 𝑡𝐶 .
❑ No transaction costs.
❑ Individuals and corporations borrow at same rate.
❑ Results
❑ Proposition I: 𝑉𝐿 = 𝑉𝑈 + 𝑡𝐶 𝐵
𝐵
❑ Proposition II: 𝑅𝑆 = 𝑅0 + (1 − 𝑡𝐶 )(𝑅0 − 𝑅𝐵 )
𝑆
❑ Intuition
❑ Proposition I: Because corporations can deduct interest
payments but not dividend payments, corporate leverage
lowers tax payments.
❑ Proposition II: The cost of equity rises with leverage
because the risk to equity rises with leverage.
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Unrealistic Assumptions
❑ Taxes were ignored.
❑ Bankruptcy costs and other agency costs
were not considered.

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Costs of Financial Distress
❑ Debt –
❑ provides tax benefits to the firm.
❑ puts pressure on the firm because interest and principal
payments are obligations which are the source of risk of
financial distress.
❑ The ultimate distress is bankruptcy, where
ownership of the firm’s assets is legally transferred
from the stockholders to the bondholders.
❑ Bankruptcy costs, or more generally financial
distress costs, tend to offset the advantages to debt.

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Static Trade-off Theory of Capital Structure

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Static Trade-off Theory of Capital Structure

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Static Trade-off Theory of Capital Structure

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The Pie Model with Real-World Factors

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The Pie Model with Real-World Factors
❑ Difference between claims –
❑ Marketable claims
❑ Nonmarketable claims.
❑ Based on transaction
❑ Dividend and interest in exchange
for payments.
❑ Taxes and legal fees in exchange for
no payments.
❑ The value of the firm = 𝑉𝑀
❑ Capital structure –
❑ Not affect the total value.
❑ Does affect 𝑽𝑴 .
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The Pie Model with Real-World Factors
Now, as a rational financial manager, what
type of capital structure would you choose?
❑ Difference between claims –
❑ Marketable claims
❑ Nonmarketable claims.
❑ Based on transaction
❑ Dividend and interest in exchange for payments
❑ Taxes and legal fees in exchange for no
payments.
❑ The value of the firm = 𝑉𝑀
❑ Capital structure
❑ Not affect the total value.
❑ Do affect 𝑉𝑀

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