Capital Structure

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Session 7

• Capital Structure

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Modigliani-Miller Propositions No Taxes

• Proposition 1
• Market value of the Firm is independent of
  capital structure.
• Proof Investors can undo capital structure
• Homemade leverage example

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Modigliani-Miller Propositions No Taxes

• Proposition 2
• Re increases as firm increases leverage.
• Proof Re Rf ? (RM - Rf)
• ?L (1D/E) ?u

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Modigliani-Miller Propositions No Taxes

• Proposition 3 (Separation Theorem)
• WACC is independent of capital structure
• (Boeing example)

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Homemade Leverage Example

• U L
• Assets 1000 1000
• Debt 0 50
• Equity 100 50
• Rd 8 8
• Re 10 12
• WACC 10 10
• EBIT 100 100
• Int 0 40
• N/Inc 100 60
• V(Equity) 1000 500
• V(Debt) 0 500

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Example

• Suppose firm chooses U -- investor wants L
• Investor Borrow 500 _at_8
• Invest 500 Own funds
• Buy U 1000
• Pay-off N/Inc 100
• Less int. 40
• Net CF 60
• Conclusion Outlay 500 of own funds
• Earned 60
• Equivalent to owning L

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Example

• Suppose firm chooses L -- investor wants U
• Investor Invest 500 in Bank _at_ 8
• Invest 500 in L
• Outlay 1000
• Pay-off N/Inc 60
• Add int. 40
• Net CF 100
• Conclusion Invested 1000 of own funds
• Earned 100
• Equivalent to owning U

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EXAMPLE BOEING
Book Value Debt
287 4.5 Equity 6131
95.5 6418 100.0 Mkt Value
Debt 271.5
1.8 Equity 14896.8
98.2 (346.443) 15168.3 100.0
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COST OF CAPITAL
Debt Bond Rate 9.73 rd
9.73 (1-0.34) 6.42 Equity CGM
re DY CGY 0.90(1.08)/39 .08
0.025 .08 10.5 CAPM re rf
?(Mkt Premium) 8.82 0.935(5.60)
8.82 5.24 14.06
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BOEINGS WACC
BV Weights WACC .0456.42 .95514.06
0.2913.43 13.72 MV Weights WACC
.0186.42 .98214.06 0.1213.81
13.93
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BOEING CASE
Target Cap Structure 25 Debt, 75
Equity ?asset ?unlevered (WE)
?equity .982.935 .918 ?tgt
?asset / (WE)tgt .918/.75 1.224
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BOEING CASE (Continued)
re rf ?(Mkt Premium) 8.82
1.224(5.6) 8.82 6.86 15.68
WACC .25(6.42) .75(15.68)
1.60 11.76 13.36
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Modigliani-MillerCorporate Taxes

• Advantage of Debt to Corporation
• Interest is tax deductible expense
• Dividends and R/inc are not

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Example

• Consider two firms with identical asset bases.
  One is all equity (U), the other has 1000 of 8
  debt
• U L
• EBIT 500 500
• Interest 0 80
• Inc Before Tax 500 420
• Tax _at_ 40 200 168
• Net Income 300 252
• Total Cash Flow (BHSH) 300 332 (80252)
• Value of Tax Shield Per Year 32 (800.4)
• All Years 400 (32/.08)

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Example Continued

• Levered firm is worth 400 more than unlevered
  firm
• In general
• VL VU TD

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Question

• If value of firm increases as leverage increases,
  why dont all firms use as much debt as possible?

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EFFECT OF FIN STRUCTURE ON WACC
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Observations on Financial Structure
1) You can make a lot more money by smart
investment decisions (real assets) than by smart
financing decisions. 2) It is very hard to guess
direction of the markets. 3) Exotic securities
of value only if you are first in the queue. And
then you better know what you are doing!
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Observations on Financial Structure

• 4) Think about distress costs. These are less
  important (i.e. you can have more debt) if
• Tangible assets
• Lower growth
• Lower R D
• Less Reliance advertising

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Observations on Financial Structure

• 5) Consider impact on firm of
• Employee losses
• Customer defections
• Lost opportunities (NPV gt 0 projects foregone)
• Slower investment
• R D
• Advertising
• Refurbishment/Replacement
• Technology