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Capital Structure Decision

MM propositions

Financial management: lecture 10


Today’s plan

 Review what we have learned in the last


lecture
 The capital structure decision
• The capital structure without taxes
• MM’s proposition 1
• MM’s proposition 2
• The capital structure with taxes
• MM’s proposition 1
• MM’s proposition 2

Financial management: lecture 10


What have we learned in the
last lecture
 In the last lecture, we have discussed
the case in the end of chapter 12, what
have you learned from this case?
 In the last lecture, we have also
discussed three forms of market
efficiency, what are they and what is
your understanding of these three forms
of market efficiency?

Financial management: lecture 10


Look at the both sides of a
balance sheet
Asset Liabilities and equity

Market value of equity


Market value of the asset E

V Market value of debt

V=E+D

Financial management: lecture 10


Capital structure
 Capital structure refers to the mix of debt and
equity in a firm.
 We often use D/E or D/V (V=D+E) to indicate
the capital structure of a firm.
• Usually, the higher the ratio, the more debt a firm has
 The capital structure problem for a firm is to
determine what is the maximum amount of
debt a firm should have to maximize the firm’s
value.

Financial management: lecture 10


Does capital structure affect the
firm value?

Debt Equity Debt


Equity Debt
Equity
wasted Govt.
Govt.

Slicing the pie doesn’t Slicing the pie can


Slicing the pie can
affect the total amount affect the size of the
affect the size of the slice
available to debt wasted slice
going to government
holders and equity holders

Financial management: lecture 10


MM’s proposition 1

 Modigliani & Miller


• If the investment opportunity is fixed,
there
are no taxes, and capital markets function
well, the market value of a company does not
depend on its capital structure.
 How can we understand this?
• The size of a pizza has nothing to do with how
you slice it.

Financial management: lecture 10


MM’s proposition 2
 Modigliani & Miller
• If the investment opportunity is fixed, there are no
taxes, and capital markets function well, the
expected rate of return on the common stock of a
levered firm increases in proportion to the debt-
equity ratio (D/E), expressed in market values.
• The WACC is independent of how the firm is
financed

Financial management: lecture 10


WACC without taxes in MM’s view
r
rE

WACC

rD
D
V
Financial management: lecture 10
M&M (Debt Policy Doesn’t Matter)
Example - River Cruises - All Equity Financed
Data
Number of shares 100,000
Price per share $10
Market Value of Shares $ 1 million

Outcome State of the Economy


Slump Expected Boom
Operating Income $75,000 125,000 175,000
Earnings per share $.75 1.25 1.75
Return on shares 7.5% 12.5% 17.5%
Financial management: lecture 10
M&M (Debt Policy Doesn’t Matter)
Data
Example
Number of shares 50,000
cont. Price per share $10
50% debt Market Value of Shares $ 500,000
Market value of debt $ 500,000

Outcome State of the Economy


Slump Expected Boom
Operating Income $75,000 125,000 175,000
Interest $50,000 50,000 50,000
Equity earnings $25,000 75,000 125,000
Earnings per share $.50 1.50 2.50
Return on shares 5% 15% 25%
Financial management: lecture 10
M&M (Debt Policy Doesn’t Matter)
Example - River Cruises - All Equity Financed
- Debt replicated by investors

Outcome State of the Economy


Slump Expected Boom
Earnings on two shares $1.50 2.50 3.50
LESS : Interest @ 10% $1.00 1.00 1.00
Net earnings on investment $.50 1.50 2.50
Return on $10 investment 5% 15% 25%

Financial management: lecture 10


Capital structure and Corporate
Taxes

 The use of debt has a lot of implications:


• Financial risk- The use of debt will increase the risk to
share holders and thus Increase the variability of
shareholder returns.
• Interest tax shield- The savings resulting from
deductibility of interest payments.

Financial management: lecture 10


An example on Tax shield
You own all the equity of Space Babies Diaper
Co.. The company has no debt. The company’s
annual cash flow is $1,000, before interest and
taxes. The corporate tax rate is 40%. You have
the option to exchange 1/2 of your equity position
for 10% bonds with a face value of $1,000.
Should you do this and why?

Financial management: lecture 10


C.S. & Corporate Taxes

All Equity 1/2 Debt


EBIT 1,000
Interest Pmt 0
Pretax Income 1,000
Taxes @ 40% 400
Net Cash Flow $600

Financial management: lecture 10


C.S. & Corporate Taxes

All Equity 1/2 Debt


EBIT 1,000 1,000
Interest Pmt 0 100
Pretax Income 1,000 900
Taxes @ 40% 400 360
Net Cash Flow $600 $540

Financial management: lecture 10


Capital Structure and Corporate
Taxes
All Equity 1/2 Debt
EBIT 1,000 1,000
Interest Pmt 0 100
Pretax Income 1,000 900
Total Cash Flow
Taxes @ 40% 400 360
All Equity = 600
Net Cash Flow $600 $540

*1/2 Debt = 640


(540 + 100)
Financial management: lecture 10
Capital Structure and tax shield

PV of Tax Shield =
D x rD x Tc
= D x Tc
rD
Example:
Tax benefit = 1000 x (.10) x (.40) = $40
PV of 40 perpetuity = 40 / .10 = $400
PV Tax Shield = D x Tc = 1000 x .4 = $400

Financial management: lecture 10


MM’s proposition 1 with tax
 firm value = value of all equity firm + PV(tax
shield)
Example,
all equality firm value =600/0.1=6,000
PV( tax shield)=400
firm value=6,400

Financial management: lecture 10


MM’s proposition 2
 Theweighted average cost of capital is
decreasing with the ratio of D/E, that is
 D   E 
WACC = (1 − Tc )rdebt  + r
 equity  
D+E D+E
 Can you understand this intuitively?

Financial management: lecture 10


WACC Graph

Financial management: lecture 10


Financial Distress

Costs of Financial Distress - Costs arising from


bankruptcy or distorted business decisions
before bankruptcy.

Market Value = Value if all Equity Financed


+ PV Tax Shield
- PV Costs of Financial
Distress

Financial management: lecture 10


Financial distress
Costs of Financial Distress - Costs arising from
bankruptcy or distorted business decisions before
bankruptcy.

Market Value = Value if all Equity Financed


+ PV Tax Shield
- PV Costs of Financial Distress

Financial management: lecture 10


Optimal Capital structure

Trade-off Theory - Theory that capital structure


is based on a trade-off between tax savings
and distress costs of debt.

Pecking Order Theory - Theory stating that


firms prefer to issue debt rather than equity if
internal finance is insufficient.

Financial management: lecture 10


Financial Distress
Maximum value of firm

Costs of
Market Value of The Firm

financial distress

PV of interest
tax shields
Value of levered firm

Value of
unlevered
firm

Optimal amount
of debt
Debt
Financial management: lecture 10