Chapter 14 CAPITAL STRUCTURE BASIC CONCEPTS Copyright 2014 McGraw Hill Education All rights reserved No reproduction or distribution without the prior written consent of McGraw Hill Education 14 1 KEY CONCEPTS AND SKILLS Describe and interpret the effect of financial leverage i e capital structure on firm earnings Define and apply homemade leverage Explain capital structure theories with and without taxes Compute the value of the unlevered and levered firm 14 2 CHAPTER OUTLINE 14 1 The Capital Structure Question and The Pie Theory 14 2 Maximizing Firm Value versus Maximizing Stockholder Interests 14 3 Financial Leverage and Firm Value An Example 14 4 Modigliani and Miller Proposition II No Taxes 14 5 Taxes 14 3 14 1 CAPITAL STRUCTURE AND THE PIE 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 S B Value of the Firm 14 4 14 2 STOCKHOLDER INTERESTS There are two important questions 1 Why should the stockholders care about maximizing firm value Perhaps they should be interested in strategies that maximize shareholder value 2 What is the ratio of debt to equity that maximizes the shareholder s value As it turns out changes in capital structure benefit the stockholders if and only if the value of the firm increases 14 5 14 3 FINANCIAL LEVERAGE EPS AND ROE Consider an all equity firm that is considering going into debt Maybe some of the original shareholders want to cash out Current Assets 20 000 Debt 0 Equity 20 000 Debt Equity ratio 0 00 Interest rate n a Shares outstanding 400 Share price 50 Proposed 20 000 8 000 12 000 2 3 8 240 50 14 6 EPS AND ROE UNDER CURRENT STRUCTURE Recession Expected Expansion EBIT 1 000 2 000 3 000 Interest 0 0 0 Net income 1 000 2 000 3 000 EPS 2 50 5 00 7 50 ROA 5 10 15 ROE 5 10 15 Current Shares Outstanding 400 shares 14 7 EPS AND ROE UNDER PROPOSED STRUCTURE Recession Expected Expansion EBIT 1 000 2 000 3 000 Interest 640 640 640 Net income 360 1 360 2 360 EPS 1 50 5 67 9 83 ROA 1 8 6 8 11 8 ROE 3 0 11 3 19 7 Proposed Shares Outstanding 240 shares 14 8 FINANCIAL LEVERAGE AND EPS 12 00 Debt 10 00 EPS 8 00 6 00 4 00 No Debt Advantage to debt Break even point 2 00 0 00 1 000 2 00 Disadvantage to debt 2 000 3 000 EBIT in dollars no taxes 14 9 ASSUMPTIONS OF THE M M MODEL Homogeneous Expectations Homogeneous Business Risk Classes Perpetual Cash Flows Perfect Capital Markets Perfect competition Firms and investors can borrow lend at the same rate Equal access to all relevant information No transaction costs No taxes 14 10 HOMEMADE LEVERAGE AN EXAMPLE Recession Expected Expansion EPS of Unlevered Firm 2 50 Earnings for 40 shares 100 Less interest on 800 8 64 Net Profits 36 ROE Net Profits 1 200 3 0 5 00 200 64 136 11 3 7 50 300 64 236 19 7 We are buying 40 shares of a 50 stock using 800 in margin We get the same ROE as if we bought into a levered firm B 800 2 Our personal debt equity ratio is 3 S 1 200 14 11 HOMEMADE UN LEVERAGE AN EXAMPLE Recession Expected Expansion EPS of Levered Firm Earnings for 24 shares Plus interest on 800 8 Net Profits ROE Net Profits 2 000 1 50 36 64 100 5 5 67 136 64 200 10 9 83 236 64 300 15 Buying 24 shares of an otherwise identical levered firm along with some of the firm s debt gets us to the ROE of the unlevered firm This is the fundamental insight of M M 14 12 MM PROPOSITION I NO TAXES We can create a levered or unlevered position by adjusting the trading in our own account This homemade leverage suggests that capital structure is irrelevant in determining the value of the firm VL VU 14 13 14 4 MM PROPOSITION II NO TAXES Proposition II Leverage increases the risk and return to stockholders Rs R0 B S R0 RB RB is the interest rate cost of debt RS is the return on levered 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 equity 14 14 MM PROPOSITION II NO TAXES The derivation is straightforward RW ACC B S RB RS B S B S B S RB RS R0 B S B S Then set RW ACC R0 B S multiply both sides by S B S B B S S B S RB RS R0 S B S S B S S B B S RB RS R0 S S B B RB RS R0 R0 S S RS R0 B R0 RB S 14 15 Cost of capital R MM PROPOSITION II NO TAXES R0 RS R0 RW ACC B R0 RB S B S RB RS B S B S RB RB Debt to equity Ratio B S 14 16 14 5 MM PROPOSITIONS I II WITH TAXES Proposition I with Corporate Taxes Firm value increases with leverage VL V U t C B Proposition II with Corporate Taxes Some of the increase in equity risk and return is offset by the interest tax shield 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 equity 14 17 MM PROPOSITION I WITH TAXES The total cash flow to all stakeholde rs is EBIT RB B 1 tC RB B The present value of this stream of cash flows is VL Clearly EBIT RB B 1 tC RB B EBIT 1 tC RB B 1 tC RB B EBIT 1 tC RB B RB Bt C RB B The present value of the first term is VU The present value of the second term is tCB VL VU tC B 14 18 MM PROPOSITION II WITH TAXES Start with M M Proposition I with taxes Since VL VU tC B VL S B S B VU tC B VU S B 1 tC The cash flows from each side of the balance sheet must equal SRS BR B VU R0 tC BR B SRS BR B S B 1 tC R0 tC RB B Divide both sides by S B B B RS RB 1 1 tC R0 tC RB S S S B Which quickly reduces to RS R0 1 tC R0 RB S 14 19 THE EFFECT OF FINANCIAL LEVERAGE Cost of capital R RS R0 B R0 …