Chapter 14

Capital Structure in
a Perfect Market
Ziwei Wang
Wuhan University
GM’s $10 Billion Apology
• On Nov 29, General Motor outlined plans for an
accelerated $10 billion share repurchase for the next
year, its largest stock buyback in recent memory.

• This is big for a company that had a market value of

just $40 billion before the announcement.

• Some $6.8 billion of stock—about 17% of the total—

will be canceled immediately, with the rest following
over the next year.

• Mechanically, that should increase analysts’ forecasts

for GM’s earnings per share next year by roughly 20%.

• The stock rose about 10% Wednesday morning.

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GM’s $10 Billion Apology
• The purpose of this cash return, according to CEO Mary Barra, is to reassure
investors about the health of GM’s core car-making business after setbacks.

• One negative shock is due to the United Auto Workers (UAW)’s campaign
against the Detroit Three: GM, Ford, and Chrysler.

• Analysts expected that wages and bene ts for the companies’ unionized
workforces will increase to $87 to $90 an hour, up from the mid-$60s now.

• That gure is much higher than those at Tesla and the foreign automakers
whose U.S. factories aren’t unionized.

• At Ford, the new UAW contract, if adopted by the membership, would add
$850 to $900 in labor expenses per vehicle.

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GM’s $10 Billion Apology
• The wage increases alone over four years total more than workers got in the
past 22 years.

• “We wholeheartedly believe that our strike squeezed every last dime out of
General Motors,” UAW President Shawn Fain said in a video.

• “We are looking forward to having everyone back to work across all of our
operations,” Barra said.

• “We have work to do,” Ford Chief Financial O cer John Lawler said
• Tesla’s chief executive Elon Musk said on his social-media platform X that the
combination of a 40% pay rise and a 32-hour working week was a “sure way
to drive GM, Ford and Chrysler bankrupt in the fast lane.”

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GM’s $10 Billion Apology

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GM’s $10 Billion Apology
• However, the company is expecting strong free-cash- ows despite the UAW
strike and new deal.

• Ironically, this comes from the fact that GM’s much-trumpeted technology
bets haven’t worked out well lately.

• GM has struggled to increase electric-vehicle output this year because of

problems with assembling battery modules.

• More recently, its big bet on driverless cars, the California robotaxi business
Cruise, has veered o course after an accident rattled regulators.

• As a response, GM has reduced its spending plan on capital expenditures,

and lowered its expectation in EV productions.

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GM’s $10 Billion Apology

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GM’s $10 Billion Apology
• GM has long struggled to translate strong earnings into a strong share price.
• The buyback is, among other things, a way to force Wall Street to take its
strong nancial performance seriously.

• But gains made at the expense of technologies that might future-proof the
business are even harder for investors to get excited about.

• The company needs to keep its EV-focused strategy on track while also
delivering steady earnings.

• Until it shows it can consistently do both in a smooth transition, expensive

buybacks won’t earn GM more than a cheap bump.

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Financing an Expansion
• As the CFO of your company, you are planning to raise $50 million in order to
expand the business.

• One possibility is to issue new shares to investors. Suppose the estimated

equity cost of capital of the company is 15%, which is the expected return of
equity holders.

• Someone in the board argues that, because the likelihood of a default is very
small, the company should be able to borrow at a very low interest rate 6%.

• Due to this low debt cost of capital, does issuing debt generate a higher value
of the company or a higher NPV of the expansion?

• In this chapter, we argue that the answer is no in perfect capital markets.

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Equity vs Debt Financing: An Example
• The relative proportions of debt, equity, and other securities (e.g. convertible
debt or warrants) that a rm has outstanding constitute its capital structure.

• Consider the following investment opportunity. For an initial cost of $800 this
year, a project will generate cash ows of either $1400 or $900 next year.

• The cash ows depend on whether the economy is strong or weak,

respectively. Both scenarios are equally likely.

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Equity vs Debt Financing: An Example
• Suppose given the project’s market risk, the appropriate risk premium is 10%.
• The risk-free interest rate is 5%. Therefore, the cost of capital for this project
is 15%.

• Now we can compute its NPV as follows

$1150
NPV = − $800 + = − $800 + $1000 = $200.
1.15
• How can the company nance this project?
• For simplicity, suppose that this is the rst investment the company is making
and it has not issued any equity or debt before.

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Equity vs Debt Financing: An Example
• If the project is nanced using equity alone, the investors should enjoy all
bene ts of the investment in Date 1.

• This means the equity cost of capital is still 15%, and such equity with no
debt is called unlevered equity.

• Hence, the market value of the rm’s equity today will be

$1150
PV(equity cash ows) = = $1000.
1.15
• This means the entrepreneur can raise $1000 by selling the equity in the rm.
It consists of $800 investment in the project and $200 remaining cash asset.
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Equity vs Debt Financing: An Example
• Now suppose the entrepreneur wants to raise part of the capital using debt.
• She borrows $500 at the risk-free interest rate of 5%, which means she will
owe $500/1.05 = $525 to debt holders in Date 1. (Why the risk-free rate?)

• Now the equity becomes levered. Given the rm’s $525 debt obligation, the
shareholders will receive only $1400 − $525 = $875 if the economy is
strong and $900 − $525 = $375 if the economy is weak.

• What price E should the levered equity sell for, and which is the best capital
structure choice for the entrepreneur?

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Equity vs Debt Financing: An Example
• Before Modigliani and Miller’s groundbreaking paper, the commonly held view
is as follows:

• The levered equity generates an expected cash ow of

0.5 × $875 + 0.5 × $375 = $625.
• Given the equity cost of capital 15%, the present value of the equity is
$625
= $543.48.
1.15
• Therefore, the NPV of the project has increased to $1043.48!
• This argument is wrong.
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Equity vs Debt Financing: An Example

• By the Law of One Price, the combined values of debt and equity must be
$1000. This means the value of the levered equity must be E = $500.

• Therefore, the entrepreneur should be indi erent between these two choices
for the rm’s capital structure.
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What Just Happened?
• As we have shown before, someone may argue that the value of the levered
equity should be higher than $500 because
0.5 × $875 + 0.5 × $375
= $543.48 > $500.
1.15
• So they tend to believe that “using leverage can increase the value of assets.”
• You should point out that the expected return of equity is not 15% anymore.

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What Just Happened?
• This is also consistent with our understanding about risk and return.
• According to CAPM, the risk premium of a risky asset should only depend on
its sensitivity to market (or systematic) risk.

• Therefore, leverage increases the risk of equity in general.

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Modigliani-Miller I

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 Modigliani-Miller I
• We have seen in the previous example that leverage would not a ect the total
value of the rm.

• Modigliani and Miller (or simply MM) showed that this result holds more
generally under a set of conditions referred to as perfect capital markets:

1. Investors and rms can trade the same set of securities at competitive
market prices equal to the present value of their future cash ows.

2. There are no taxes, transaction costs, or issuance costs associated with

security trading.

3. A rm’s nancing decisions do not change the cash ows generated by its
investments, nor do they reveal new information about them.

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 Modigliani-Miller I
• MM Proposition I: In a perfect capital market, the total value of a rm’s
securities is equal to the market value of the total cash ows generated by its
assets and is not a ected by its choice of capital structure.

• As a student of corporate nance in 2022, you can prove this pretty easily.
• Consider two identical rms whose assets can generate cash ows X.
• Suppose the rst rm is nanced by equity E1 only, while the second rm is
nanced by debt D2 and equity E2.

• Because the asset is a portfolio of debt and equity, its cash ows X pays o the
debt and equity. By Law of One Price, PV(X) = E1. By Law of One Price again,
PV(X) = D2 + E2. Therefore, E1 = D2 + E2.
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Modigliani-Miller I
• Although this proposition seems almost trivial, it was not that obvious back
then.

• What Modigliani-Miller did was exactly how we prove the Law of One Price: If
not true, we can construct an arbitrage portfolio and earn a free lunch.

• The idea is that an investor can always adjust the ratio of debt and equity by
using homemade leverage, i.e. she buys or sells debts in the market herself.

• They considered two cases: E1 < E2 + D2 and E1 > E2 + D2.

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Modigliani-Miller I
• Case one: E1 < E2 + D2.
• Construct a portfolio as follows:
• First, short αE2, which generates (random) cash ows −α(X − rD2).
• Then, borrow (sell) αD2 yourself, which requires you to pay −rαD2 each
period.

• Finally, long αE1, which pays you cash ows αX.

• Therefore, the future cash ows are −α(X − rD2) − rαD2 + αX = 0. While
today you get α(E2 + D2 − E1) > 0, which is a free lunch!

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Modigliani-Miller I
• Case two: E1 > E2 + D2.
• We can simply ip everything we did in case one.
• Left as an exercise.

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Modigliani-Miller I
Problem (Example 14.2 in textbook)

Suppose there are two rms, each with date 1 cash ows of $1400 or $900 (as
in the rst example). The rms are identical except for their capital structure.
One rm is unlevered, and its equity has a market value of $990. The other rm
has borrowed $500, and its equity has a market value of $510. Does MM
Proposition I hold? What arbitrage opportunity is available using homemade
leverage?

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Modigliani-Miller I
• According to Michael Dempsey’s book, “Stock Markets and Corporate
Finance,” at the time, both Modigliani and Miller were professors at the
Graduate School of Industrial Administration at Carnegie Mellon University.

• Both were required to teach corporate nance to business students but,

unhappily, neither had any experience in corporate nance (like me).

• After reading the course

materials that they were to use,
the two professors found the
information inconsistent and
the concepts awed.

• So, they worked together to

correct them.
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Modigliani-Miller I
Merton Miller:

People often ask: Can you summarize your theory quickly? Well, I say, you
understand the M&M theorem if you know why this is a joke: The pizza delivery
man comes to Yogi Berra after the game and says, “Yogi, how do you want this
pizza cut, into quarters or eighths?” And Yogi says, “Cut it in eight pieces. I’m
feeling hungry tonight.”

Everyone recognizes that’s a joke because obviously the number and shape of
the pieces don’t a ect the size of the pizza. And similarly, the stocks, bonds,
warrants, et cetera, issued don’t a ect the aggregate value of the rm. They just
slice up the underlying earnings in di erent ways.

From Peter J. Tanous, Investment Gurus (Prentice Hall Press, 1997).

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Modigliani-Miller I
Also Merton Miller:

Think of the rm as a gigantic tub of whole milk. The farmer can sell the whole
milk as is. Or he can separate out the cream and sell it at a considerably higher
price than the whole milk would bring. (That's the analog of a rm selling low-
yield and hence high-priced debt securities.) But, of course, what the farmer
would have left would be skim milk with low butterfat content and that would sell
for much less than whole milk. That corresponds to the levered equity. The M
and M proposition says that if there were no costs of separation (and, of course,
no government dairy-support programs), the cream plus the skim milk would
bring the same price as the whole milk.

From Merton Miller, Financial Innovations and Market Volatility.

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The Market Value Balance Sheet

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The Market Value Balance Sheet
Problem (Example 14.3 in textbook)

Suppose our entrepreneur decides to sell the rm by splitting it into three

securities: equity, $500 of debt, and a third security called a warrant that pays
$210 when the rm’s cash ows are high and nothing when the cash ows are
low. Suppose that this third security is priced at $60.

(a) Verify that the third security is priced fairly.

(b) What will the value of the equity be in a perfect capital market?

(c) Verify that the equity is also priced fairly.

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注意这里衔接了14.1的例子，1000是从
那一块得出来的
A Leveraged Recapitalization
• When a rm repurchases a signi cant percentage of its outstanding shares by
issuing debts, the transaction is called a leveraged recapitalization.

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Modigliani-Miller II
• As we have seen before, while debt itself may be cheap, it increases the risk
and therefore the cost of capital of the rm’s equity.

• We now quantify this e ect, and calculate the impact of leverage on the
expected return of a rm’s stock, or the equity cost of capital.

• Let E and D denote the market value of equity and debt if the rm is levered,
respectively; let U be the market value of equity if the rm is unlevered; and
let A be the market value of the rm’s assets.

• MM I says VL=E+D Vu

E + D = U = A. Assets=Debt+Equity

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Modigliani-Miller II
• Because the return of a portfolio is equal to the weighted average of the
returns of the securities in it, we have
E D
RE + RD = RU.
E+D E+D
• Rearranging the equation above yields
D
RE = RU + (RU − RD).
E
• The levered equity return equals the unlevered return, plus an extra “kick” due
to leverage. This kick magni es the volatility of levered equity return.

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 Modigliani-Miller II
• This equation still holds if we take expectations on both sides. Then it
becomes a relation between expected returns (denoted by r in place of R).

• MM Proposition II: The cost of capital of levered equity increases with the
rm’s market value debt-equity ratio,
D
rE = rU + (rU − rD).
E
• We can verify this equation using our motivating example
500
rE = 15% + (15% − 5%) = 25 % .
500

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Modigliani-Miller II
• In Chapter 12, we de ned the (after-tax) weighted average cost of capital
(WACC), which is equal to the unlevered cost of capital when capital markets
are perfect.

• This means
E D
rWACC = rU = rE + rD.
E+D E+D
• Therefore, as a corollary, with perfect capital markets, a rm’s WACC and
enterprise value is independent of its capital structure and is equal to its equity
cost of capital if it is unlevered, which matches the cost of capital of its assets.

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Modigliani-Miller II

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Modigliani-Miller II
Problem (Example 14.5 in textbook)

NRG Energy, Inc. (NRG) is an energy company with a market debt-equity ratio of
2. Suppose its current debt cost of capital is 6%, and its equity cost of capital is
12%. Suppose also that if NRG issues equity and uses the proceeds to repay its
junior debt and reduce its debt-equity ratio to 1, it will lower its debt cost of
capital to 5.5%.

(a) With perfect capital markets, what e ect will this transaction have on NRG’s
equity cost of capital and WACC?

(b) What would happen if NRG issues even more equity and pays o its debt
completely?

(c) How would these alternative capital structures a ect NRG’s enterprise value?
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Modigliani-Miller II
• In Chapter 12, we have shown that a rm’s unlevered or asset beta is the
weighted average of its equity and debt beta
E D
βU = βE + βD.
E+D E+D
• Rearranging the equation above yields
D
βE = βU + (βU − βD).
E
• This equation is analogous to the one for expected returns.

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Modigliani-Miller II
Problem (Example 14.7 in textbook)

Suppose drug retailer CVS has an equity beta of 0.8 and a debt-equity ratio of
0.1. Estimate its asset beta assuming its debt beta is zero. Suppose CVS were
to increase its leverage so that its debt-equity ratio was 0.5. Assuming its debt
beta were still zero, what would you expect its equity beta to be after the
increase in leverage?

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How MM Challenges the Doctrines
• Their proposition I implies that, the average cost of capital is a constant,
independent of the capital structure.

• The conventional view was that, the average cost of capital should tend to fall
with increasing leverage, because debt- nancing should be “cheaper” than
equity- nancing if not carried too far.

• When leverage is too high, the stock yields start to rise, which gives a U-
shaped curve of average cost of capital as a function of D/(E+D).

• An “optimal” capital structure should be at the bottom of the U-shaped curve.

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How MM Challenges the Doctrines

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How MM Challenges the Doctrines
• Their proposition II implies that, the equity cost of capital is a linear function of
the debt to equity ratio (D/E).

• The traditional view says the yield of stock should not change for
“reasonable” amount of leverage.

• Beyond a certain threshold, the yield will sharply rise as the market discounts
“excessive” trading on the equity.

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How MM Challenges the Doctrines

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How MM Challenges the Doctrines
• Modigliani and Miller collect some data that shows preliminary evidence on
their basic propositions.

• They run regressions using (1) the average value of actual net returns in 1947
and 1948 of utilities companies in F. B. Allen (1954); and (2) actual net returns
in 1953 of oil companies in R. Smith (1955).

• The regression results support their propositions.

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How MM Challenges the Doctrines

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How MM Challenges the Doctrines

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Leverage and EPS: A Fallacy (谬论)
• Leverage can increase a rm’s expected earnings per share.
• An argument sometimes made is that by doing so, leverage should also
increase the rm’s stock price.

• Consider the following example. Levitron Industries (LVI) is currently an all-

equity rm. It expects to generate earnings before interest and taxes (EBIT) of
$10 million over the next year.

• Currently, LVI has 10 million shares outstanding, and its stock is trading for a
price of $7.50 per share.

• LVI is considering changing its capital structure by borrowing $15 million at an

interest rate of 8% and using the proceeds to repurchase 2 million shares at
$7.50 per share.
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Leverage and EPS: A Fallacy (谬论)
• The expected earnings per share without debt is
$10 million
EPS = = $1.
10 million
• The new debt will obligate LVI to make interest payments of $1.2 million each
year, reducing its earnings to $8.8 million.

• Therefore, the expected earnings per share with leverage becomes

$8.8 million
EPS = = $1.1.
8 million
• LVI’s expected earnings per share increases with leverage.
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 Leverage and EPS: A Fallacy (谬论)
• This increase might appear to make shareholders better o and could
potentially lead to an increase in the stock price.

• But by MM I, the leveraged recapitalization should not change the value of the
rm and thus should o er no bene t to shareholders.

• How can we reconcile these “contradictory” results?

• The answer is that, just like equity, the risk of EPS has also changed.
• And we have only considered the increase in expected EPS.

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Leverage and EPS: A Fallacy (谬论)

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Leverage and EPS: A Fallacy (谬论)
Problem (Example 14.9 in textbook)

Assume that LVI’s EBIT is not expected to grow in the future and that all
earnings are paid as dividends. Use MM Propositions I and II to show that the
increase in expected EPS for LVI will not lead to an increase in the share price.

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？？
Dilution: Another Fallacy
• Another often-heard fallacy is that issuing equity will dilute existing
shareholders’ ownership, so debt nancing should be used instead.

• That is, if the rm issues new shares, the cash ows in the future must be
divided among a larger number of shares, thereby reducing the value of each
individual share.

• The problem with this line of reasoning is that it ignores the fact that the cash
raised by issuing new shares will increase the rm’s assets.

• These new assets can either be used to generate new free-cash- ows or to
reduce the risk of existing assets.

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 Dilution: Another Fallacy
• Consider a simple example of Jet Sky Airlines (JSA), a highly successful
discount airline.

• It currently has no debt and 500 million shares of stock outstanding. These
shares are currently trading at $16.

• Last month the rm announced that it would expand its operations. The
expansion will require the purchase of $1 billion of new planes, which will be
nanced by issuing new equity.

• How will the share price change when the new equity is issued today?

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Dilution: Another Fallacy =500+1000/16

• Based on the current share price of the rm (prior to the issue), the equity and
therefore the assets of the rm have a market value of 500 million shares ×
$16 per share = $8 billion.

• Because the expansion decision has already been made and announced, in
perfect capital markets this value incorporates the NPV associated with the
expansion.
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Dilution: Another Fallacy

• Two things happen when JSA issues equity. First, the market value of its
assets grows because of the additional $1 billion in cash the rm has raised.

• Second, the number of shares increases. Although the number of shares has
grown to 562.5 million, the value per share is unchanged: $9 billion ÷ 562.5
million shares = $16 per share.

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Dilution: Another Fallacy

• As long as the rm 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.

• Any gain or loss associated with the transaction will result from the NPV of the
investments the rm makes with the funds raised.

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Exercise
Yerba Industries is an all-equity rm whose stock has a beta of 0.90 and an
expected return of 16.5%. Suppose it issues new risk-free debt with a 6% yield
and repurchases 55% of its stock. Assume perfect capital markets.

(a) What is the beta of Yerba stock after this transaction?

(b) What is the expected return of Yerba stock after this transaction?

Suppose that prior to this transaction, Yerba expected earnings per share this
coming year of $5, with a forward P/E ratio (that is, the share price divided by
the expected earnings for the coming year) of 9.

(c) What is Yerba’s expected earnings per share after this transaction? Does this
change bene t shareholders? Explain.
(d) What is Yerba’s forward P/E ratio after this transaction? Is this change in the
P/E ratio reasonable? Explain.
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