Capital Structure: Part 1

1
Capital Structure Part 1

• For 9.220, Term 1, 2002/03
• 02_Lecture19.ppt
• Student Version

2
Outline

• Introduction
• Theories of Capital Structure
• Modigliani and Miller No tax
• MM with Corporate Tax
• Summary and Conclusions (so far)

3
Introduction

• Definition Capital Structure is the mix of
  financial securities used to finance the firm.
• Our goal is to see if there is an optimal way for
  firms to finance.
• Should a firm have a higher or lower D/E ratio.
• What factors affect the optimal D/E choice?
• In order to optimize the D/E ratio, our overall
  goal is to maximize the total value of the firm
  and thus maximize expected shareholder wealth.

4
Modigliani and Miller No Tax Case

• MM began looking at capital structure in a very
  simplified world so that we would know what does
  or does not matter.
• Assume no taxes
• No transaction costs
• Including no bankruptcy costs
• Investors can borrow/lend at the same rate (the
  same as the firm).
• No information asymmetries
• A fixed investment policy by the firm

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MM No Tax Result

• A change in capital structure does not matter to
  the overall value of the firm. The total cash
  flows produced are the same, thus the total value
  of the cash flows is the same.
• It doesnt matter if the cash flows from the firm
  to its security holders are called debt or equity
  cash flows.

6
MM No Tax Case
Equity,
1,000,
100
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The MM Propositions I II (No Taxes)

• Proposition I
• Firm value is not affected by leverage
• VL VU
• Proposition II
• Leverage increases the risk and return to
  stockholders
• rs r0 (B / SL) (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
• SL is the value of levered equity

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MM Proposition I (No Taxes)
The derivation is straightforward
The present value of this stream of cash flows is
VL
The present value of this stream of cash flows is
VU
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MM Proposition II (No Taxes)
The derivation is straightforward
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Exercise

• Suppose the firm is currently all equity financed
  and the total value of the firm is 90 million.
  ERequity is 18. Also, suppose Rf 4 and
  ERM 14.
• What is the value of the equity and the total
  value of the firm if the capital structure is
  changed to include 30 million of debt? If
  ERdebt is 6, then what is the new ERequity?
  What is the WACC? Compare the beta of the levered
  equity to the unlevered equity. What is the
  weighted beta of the firms securities?
• Redo 1 with 60 million of debt.

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The Cost of Equity Debt, and the WACC MM
Proposition II with No Corporate Taxes
Cost of capital r ()
r0
rB
rB
Debt-to-equity Ratio
12
MM with Corporate Taxes

• When corporate taxes are introduced, then debt
  financing causes a positive benefit to the value
  of the firm.
• The reason for this is that debt interest
  payments reduce taxable income and thus reduce
  taxes.
• Thus with debt, there is more after-tax cash flow
  available to security holders (equity and debt)
  than there is without debt.
• Thus the value of the equity and debt securities
  combined is greater.

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MM with Corporate Taxes
TC 40 in this example
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MM Proposition I (with Corporate Taxes)

• Proposition I (with Corporate Taxes)
• Firm value increases with leverage
• VL VU TC B

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MM Proposition I (with Corp. Taxes)
The present value of this stream of cash flows is
VL
The present value of the first term is VU The
present value of the second term is TCB
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MM Proposition II (with Corp. Taxes)

• Proposition II (with Corporate Taxes)
• This proposition is similar to Prop. II in the no
  tax case, however, now the risk and return of
  equity does not rise as quickly as the
  debt/equity ratio is increased because low-risk
  tax cash flows are saved.
• Some of the increase in equity risk and return is
  offset by 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 levered equity

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Exercise

• Suppose the firm is currently all equity financed
  and the total value of the firm is 90 million.
  ERequity is 18. Also, suppose that TC 40,
  Rf 4 and ERM 14.
• What is the value of the equity and the total
  value of the firm if the capital structure is
  changed to include 30 million of debt? If
  ERdebt is 6, then what is the new ERequity?
  What is the new WACC?
• Redo 1 with 60 million of debt.

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The Effect of Financial Leverage on the Cost of
Debt and Equity Capital
Cost of capital r()
r0
rB
Debt-to-equityratio (B/S)
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Summary and Conclusions

• At this point, it appears clear that an increase
  in the debt/equity ratio increases the risk of
  the equity.
• With corporate taxes, it also appears that the
  value of the firm increases as the amount of debt
  used increases (due to taxes being saved).
• However, in reality, we dont see 100 debt
  financing, so there must be other factors that
  affect the firms optimal capital structure.
• The next lecture addresses these other factors
  and extends the theory.