Homemade Leverage - Example

Co. A and Co. B are identical firms in all respects except for their
capital structure. B is all equity financed with 1,500,000 in
stock. A uses both stock and perpetual debt: its stock worth
900,000 and the interest rate on the debt is 10 percent. Both
firms expect EBIT to be $120,000,000. Ignore taxes.

a)Wamiq owns 45 million worth of A shares. What will be the

earning from A if all income is distributed?
b)Show how Wamiq could generate exactly the same earning by
investing in B and using homemade leverage?
c)What is the cost of equity for A? What is it for B?
d)What is the WACC for A? For B? What principle have you
illustrated?
 MM Propositions I & II (With Taxes)
• Proposition I (with Corporate Taxes)
– Firm value increases with leverage
VL = VU + TC B
• Proposition II (with Corporate Taxes)
– Some of the increase in equity risk and return is
offset by the interest tax benefit
RS = R0 + (B/S)×(1-TC)×(R0 - RB)
RB is the interest rate (cost of debt)
RS is the return on equity (cost of equity)
R0 is the return on unlevered equity (cost of capital)
B is the value of debt
S is the value of levered equity
 Summary: No Taxes
• In a world of no taxes, the value of the firm is unaffected by
capital structure.
• This is M&M Proposition I:
VL = VU
• Proposition I holds because shareholders can achieve any
pattern of payouts they desire with homemade leverage.
• In a world of no taxes, M&M Proposition II states that leverage
increases the risk and return to stockholders.

B
RS  R0   ( R0  RB )
SL
 Summary: Taxes
• In a world of taxes, but no bankruptcy costs, the value of the
firm increases with leverage.
• This is M&M Proposition I:
VL = VU + TC B
• Proposition I holds because shareholders can achieve any
pattern of payouts they desire with homemade leverage.
• In a world of taxes, M&M Proposition II states that leverage
increases the risk and return
B to stockholders.
RS  R0   (1  TC )  ( R0  RB )
SL
 Interpreting WACC
• Tax Vs no tax
• Cost of debt financing increases the risk for
equity holders so their expectation of return
becomes higher…..meaning that incremental
debt financing can increase the WACC
• It provides a bench mark below which
investments should not be made
 CAPM
Ri = Rf + Bi (Rm – Rf)
Sensitivity of a stock to market = Beta
Premium required over risk free return
Betas reflect the sensitivity of each firm’s profits to the general health of the
economy. For example, Technology stocks have high betas (well over 1) because
demand for their products usually varies with the business cycle: Companies and
consumers tend to invest in technology when times are good, but they cut back
on these expenditures when the economy slows. In contrast, the demand for
personal and household products has very little relation to the state of the
economy. Firms producing these goods, such as Procter & Gamble, tend to have
very low betas (near 0.5).
 Example
Share price = 90, Government bond rate = 7%,
Share price fluctuates twice as average market, 100 index return = 14.5%
Tax rate = 20%, CPI (Inflation) = 13%, Population growth rate = 2.3%,
Corruption rate = 99.9%

Ri = What is the cost of Equity?

Rf = 7%
Rm= 14.5%
B=2