FINA1082 Financial Management

Dr. Lianfeng Quan

Senior Lecturer in Accounting and Finance
Room QA348 – Department of Accounting and Finance

Email: [email protected]
Lecture 13
Capital Structure I

January, 15, 2014

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Essential Readings:
Hillier et al Chapter 15
Brealey et al. Chapter 17
 Learning Outcomes
By the end of this session, you should be able to
•Understand the effect of financial leverage (i.e.,
capital structure) on firm earnings
•Critically discuss capital structure theories with
and without taxes (MM Proposition I and II)
•Compute the value of the unlevered and levered
firm
•Understand the effect of corporate taxes on
capital structure

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 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

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 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?

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 Maximising Firm Value vs Maximising
Shareholder Interests

S B

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. 7
 Maximising Firm Value vs Shareholder
Interests Example
The market value of ABC plc is £1,000. ABC currently has
no debt, and each of ABC’s 100 shares sells for £10.
Suppose that ABC plans to borrow £500 and pay the £500
proceeds to shareholders as an extra cash dividend of £5
per share. What will the value of the firm be after the
proposed restructuring?

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 Maximising Firm Value vs Shareholder
Interests Example (Cont.)

• Changes in capital structure benefit the shareholders if

and only if the value of the firm increases
• Managers should choose the capital structure that they
believe will have the highest firm value because this
capital structure will be most beneficial to the firm’s
shareholders
 Financial Leverage and Firm Value:
An Example

The current structure is all equity.

The proposed capital structure has leverage.
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Current Capital
Structure: No
Debt
Proposed Capital
Structure:
Debt = €4,000
 Current Capital Structure: No Debt

Proposed Capital Structure: Debt = €4,000

The effect of financial leverage depends on the company’s

earnings before interest.
 EBI  I EBI  0 EBI  €400
EPS   
N 400 200
Earnings  €800

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 The Effect of Financial Leverage
• The effect of financial leverage depends upon
EBIT
– When EBIT is high, financial leverage raised ROE
and EPS
• The variability of ROE and EPS is increasing
with financial leverage
– Higher financial leverage magnifies the effect of
changes in EBIT on ROE and EPS. Using more debt
makes ROE and EPS more risky.

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 Homemade Leverage
Homemade leverage: the use of personal borrowing/lending to
change the overall amount of financial leverage to which the
individual is exposed.

Example: Suppose the firm did not change its capital structure.
• Investors can replicate the returns from the proposed capital
structure by borrowing on their own.
• Suppose a shareholder wants to invest € 2000 in the firm, and
prefers the proposed rather than the current capital structure.
• If the proposed capital structure is not adopted, she buys 100
shares with her own money, and additional 100 shares by
borrowing € 2000 at 10% interest.
• She replicates the returns under the proposed capital structure
while the cost of the investment is the same.
 The Choice Between Debt and Equity

firm

The firm neither helps nor hurts its stockholders by restructuring

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 Homemade Leverage (Cont.)
• Suppose that investors can borrow or lend at the
same rate as the corporation.
• Then investors can always use homemade leverage
to “undo” in their own portfolios any change in a
firm’s capital structure choice.
• So they can attain the same cash flows that they
would have attained without the firm’s leverage
change.
• Therefore, investors are indifferent to changes in the
firm’s capital structure and share prices should be
the same regardless of the firm’s capital structure.
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 Modigliani and Miller (MM)
Proposition I (No Taxes)
• The value of the levered firm is the same as the
value of the unlevered firm.
– Because stockholders’ welfare is directly related to the
firm’s value, the changes in capital structure cannot
affect the stockholders’ welfare.

• MM Proposition I: Key Assumptions

– Individuals can borrow as cheaply as corporations. Is this
realistic?
– No Taxes
– No Transaction Costs 19
 MM Proposition II (No Taxes)
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

Because levered equity has greater risk, it should have a

greater expected return as compensation.
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 B S
RW ACC   RB   RS
MM Proposition II BS BS
0 $8,000
(No Taxes) Unlevered firm :15%   10%   15%
$8,000 $8,000
$4,000 $4,000
Levered firm :15%   10%   20%
The derivation is: $8,000 $8,000
B S
RW ACC   RB   RS Then set RW ACC  R0
BS BS
B S BS
 RB   RS  R0 multiply both sides by
BS BS 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 B
 RB  RS  R0  R0 RS  R0  ( R0  RB )
S S S
MM Proposition II (No Taxes)

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 MM Propositions I and II Example
Canary Motors, an all-equity firm, has expected
earnings of £10 million per year in perpetuity. The firm
pays all of its earnings out as dividends, so the £10
million may also be viewed as the shareholders’
expected cash flow. There are 10 million shares
outstanding, implying expected annual cash flow of £1
per share. The cost of capital for this unlevered firm is
10%. In addition, the firm will soon build a new plant
for £4 million. The plant is expected to generate
additional cash flow of £1 million per year.
•What is the NPV of the new plant?
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 MM Propositions I and II Example
Canary Motors, an all-equity firm, has expected earnings of £10 million
per year in perpetuity. The firm pays all of its earnings out as
dividends, so the £10 million may also be viewed as the shareholders’
expected cash flow. There are 10 million shares outstanding, implying
expected annual cash flow of £1 per share. The cost of capital for this
unlevered firm is 10%. In addition, the firm will soon build a new plant
for £4 million. The plant is expected to generate additional cash flow of
£1 million per year.
•What is the NPV of the new plant?

£1million
NPV  £4 million   £6 million
.1
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Before the market knows of the project:

•Equity Financing:

The stock price, and the value of the firm, will immediately rise to
reflect the positive NPV of the plant.
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• Equity Financing cont.:
– funds are put in the bank temporarily before used to build the plant.

– Note that the stock price has not changed (£10.6).

• Assume the plant is built immediately.

• Expected yearly cash flow from the firm is £11 million, £10
million of which comes from the old assets and £1 million
from the new.
• The expected return to equity holders is:
RS =£11 million/£110 million=10%

• Because the firm is all equity, RS = R0 = 10%

• Debt Financing:
Borrow £4 million at 6% to build the new plant.

The value of the firm is the same as in the equity financing case
because (1) the same plant is to be built and (2) MM proved that
debt financing is neither better nor worse than equity financing.
Debt Financing cont:

Yearly cash flow after interest= £10m + £1m - £4m x 6% = £10.76m

Expected return to levered equity holders = £10.76m /£106m = 10.15%
B
RS  R0   (R0  RB )
S
£4,000,000
10.15%  10%   (10%  6%)
£106,000,000
The example illustrates the aspects of MM Proposition:
•consistent with MM I because the value of the firm is $110 million after either
equity or debt financing.
•consistent with MM II. The expected return to equity holders rises from 10%
to 10.15% because levered equity holders face more risk.
 Corporate Taxes

The levered firm pays less in taxes than does the all-equity
firm. Thus the sum of the debt plus the equity of the levered
firm is greater than the equity of the unlevered firm.
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 Taxes and Cash Flow: Example
ABC company has a corporate tax rate, tC, of 35%
and expected earnings before interest and taxes
(EBIT) of €1 million each year. Its entire earnings
after taxes are paid out as dividends.
The firm is considering two alternative capital
structures.
•Under Plan I, ABC would have no debt in its capital
structure.
•Under Plan II, the company would have €4 million of debt,
B. The cost of debt, RB, is 10%.
What is the total cash flow to shareholders and
bondholders under each scenario? 31
Taxes and Cash Flow: Example

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 Present Value of the Tax Shield

Reduction in Corporate Taxes:

Assuming Cash Flows are Perpetual, Present Value of Tax Shield:

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 MM Proposition I with Corporate
Taxes
The value of an unlevered firm

EBIT    tC )
VU 
R0
MM Proposition I (Corporate Taxes):

EBIT    tC ) tC RB B
VL    VU  tC B
R0 RB
 MM I with Corporate Taxes: Example
ABC Airlines is currently an unlevered firm. The
company expects to generate €153.85 in earnings
before interest and taxes (EBIT) in perpetuity. The
corporate tax rate is 35%, implying after tax earnings
of €100. All earnings after tax are paid out as
dividends.
The firm is considering a capital restructuring to
allow €200 of debt. Its cost of debt capital is 10%.
Unlevered firms in the same industry have a cost of
equity capital of 20%.
What will the new value of ABC Airlines be?
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 MM I with Corporate Taxes: Example
EBIT    tC )
VL   tC B
R0
€100
  (.35  €200)
.20
 €500  €70  €570
 MM Proposition II with Corporate
Taxes
• MM Proposition II (Corporate Taxes):
B
RS  R0     tC )   R 0  RB )
S
• Leverage adds risk to the
firm’s equity.
– As compensation, the cost
of equity rises with the
firm’s risk.
• Debt is tax-advantaged
relative to equity, so RWACC
declines with leverage
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 WACC and Corporate Taxes
S B
RWACC  RS  RB (1  tC )
VL VL
370 200
RWACC (  0.2351)  (  10%  65%)  17.54%
570 570
• So reduced its RWACC from .20 (with no debt) to .1754 with
reliance on debt.
• When a firm lowers its RWACC , the firm’s value will
increase.
EBIT  (1  t C ) 100
VL    570
RWACC 0.1754

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 MM Propositions with Taxes
Summary
• Assumptions
– Corporations are taxed at the rate tC, on earnings after
interest
– No transaction costs
– Individuals and corporations borrow at same rate
• Proposition I
– VL = VU + tCB (for a firm with perpetual debt)

– Because corporations can deduct interest payments,

corporate leverage lowers tax payments

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 MM Propositions with Taxes
Summary (Cont.)
• Proposition II
B
RS  R0  (1  tC )( R0  RB )
S
– The cost of equity rises with leverage because the risk
to equity rises with leverage
– Value is positively related to leverage.

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 Recap Lecture 13
• Understand the effect of financial leverage (i.e.,
capital structure) on firm earnings
• Critically discuss capital structure theories with and
without taxes (MM Proposition I and II)
• Be able to compute the value of the unlevered and
levered firm
• Understand the effect of corporate taxes on capital
structure.

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 Next Lecture
• Define the costs associated with bankruptcy
• Understand the theories that address the level of
debt a firm carries
– Tradeoff
– Signaling
– Agency Cost
– Pecking Order
• Critically discuss real world factors that affect the
debt to equity ratio

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