Lecture 3: Capital Structure 1

FNCE201 Corporate Finance

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Capital Structure

The capital structure of the firm is defined by how its assets are
financed. It represents the mix of claims against the firm’s assets
and cash flows.

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The Choice between Debt and Equity

Question 1
An entrepreneur is considering the following investment opportunity.
For an initial investment of $800 this year, a project will generate free
cash flows of either $1,400 or $900 next year, depending on whether
the economy is strong or weak, respectively. Both scenarios are
equally likely. Project cash flows depend on the overall economy and
therefore contain market risk. As a result, investors demand a 10%
risk premium over the current risk-free rate of 5% to invest in this
project.

What is the NPV of this project?

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The Choice between Debt and Equity
To raise funds for the initial investment, the project is sold to
investors as an all-equity firm. Equity holders will receive the
cash flows of the project in one year.

The amount of funds that the project can raise i.e. the initial
market value of the unlevered equity is therefore:

Date 0 Date 1 Cash Flows

Initial Value Strong Weak
Unlevered equity

Since there is no debt, the cash flows of the unlevered equity are
equal to those of the project.
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The Choice between Debt and Equity
Suppose the entrepreneur decides to borrow $500 initially, in
addition to selling equity. Since the project’s cash flow will
always be enough to repay the debt, the debt is risk-free and,
therefore, she can borrow at the risk-free rate of 5%.

Date 0 Date 1 Cash Flows

Initial Value Strong Weak
Debt
Levered Equity
Firm

Levered Equity. Equity in a firm that also has debt

outstanding.

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What Price should Levered Equity sell for?

Law of One Price. In competitive markets, securities or

portfolios with the same cash flows must have the same price.

Assuming perfect capital markets, the firm’s total cash flows

(Debt + Levered Equity) must equal the cash flows of the
project (in strong and weak states) and therefore must have the
same present value (i.e. 500 + E = 1, 000)

Date 0 Date 1 Cash Flows

Initial Value Strong Weak
Debt
Levered Equity E
Firm

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The Choice between Debt and Equity
Since the cash flows of levered equity are smaller than the cash
flows of unlevered equity, levered equity will sell for a lower price.

Date 0 Date 1 Cash Flows

Initial Value Strong Weak
Levered Equity
Unlevered Equity

However, the entrepreneur is not worse off since she will still
raise the same amount issuing both debt and levered equity, just
as she did with unlevered equity alone.

As a result, she will be indifferent between the two choices of

the firm’s capital structure.
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 Part I

Modigliani-Miller Proposition I

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Capital Structure
The “pizza theory” says that the MV of the firm’s assets (the
pizza) cannot be increased by changing the proportions of cash
flows (the slices) going to shareholders and debt holders, under a
restrictive set of assumptions.

The market value of a firm’s assets is therefore not determined

by the relative proportions of debt and equity capital used to
finance the assets.
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The Modigliani-Miller (MM) Theorem

The formal proof of the theory was provided by Modigliani and

Miller (MM) who showed that under perfect capital market
conditions, a firm’s value should be unaffected by its capital
structure:
– No taxes, financial distress costs and transactions costs.

– No asymmetric information i.e. no one knows more than

anyone else about the true firm value.

– Capital structure does not affect investment decisions i.e.

investment policy is given no matter what a firm’s capital
structure is.

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The Modigliani-Miller (MM) Theorem
MM Proposition I
In a perfect capital market, the total value of a firm is equal to the
market value of the total cash flows generated by its assets and is not
affected by its choice of capital structure.

The intuition behind the MM Proposition I is that the value of a

firm’s assets is determined only by the ability of its managers to
generate as much cash flow as possible from these assets, not by
reshuffling paper claims on these cash flows.

MM established their result by arguing that assuming perfect

capital markets, the total cash flow paid out to all of the firm’s
security holders is equal to the cash flow generated by the firm’s
assets.
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MM Proposition I
In an all-equity company, all the cash flows are available to
equity holders and therefore the value of the firm is the present
value of these cash flows.

By the Law of One Price, the firm’s equity and its assets must
have the same total market value.
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MM Proposition I
If the same company is partially financed by debt, these cash
flows are split between the equity holders and debt holders.

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MM Proposition I
Therefore, the sum of the values of debt and equity should equal
the value of the all-equity company.

The value of the firm is determined solely by its cash flows, not
by the relative reliance on debt and equity capital.

Accordingly, D + E = U = A, where D, E , U, and A, are the

market values of debt, equity, the unlevered firm, and the firm’s
assets, respectively.
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Homemade Leverage

Homemade leverage. When investors use leverage in their

own portfolios to adjust the leverage choices made by the firm

Consider an all-equity firm and an investor who prefers holding

levered equity. Using homemade leverage, the investor can
replicate the payoffs to levered equity by borrowing at the
risk-free rate:
Date 0 Date 1 Cash Flows
Initial Cost Strong Weak
Unlevered Equity
Loan
Levered Equity

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Homemade Leverage
If the firm now uses debt, but the investor prefers holding
unlevered equity, the investor can recreate the payoffs of
unlevered equity by buying both the debt and the equity of the
firm:
Date 0 Date 1 Cash Flows
Initial Cost Strong Weak
Debt
Levered Equity
Unlevered Equity

Combining the cash flows of the two securities produces cash

flows identical to unlevered equity.

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Homemade Leverage

In both cases, the choice of capital structure does not affect the
opportunities available to investors since they can alter the
leverage choice of the firm to suit their personal tastes either by
adding leverage or by reducing leverage.

With perfect capital markets, different choices of capital

structure offer no benefit to investors and does not affect the
value of the firm.

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Application of MM Proposition I: The Market
Value Balance Sheet

All assets and liabilities of the firm are included, even intangible
assets e.g. reputation, brand name.

All values are in current market values.

The total value of all securities issued by the firm must equal the
total value of the firm’s assets:

E +D =A=U (1)

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The Market Value Balance Sheet

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The Market Value Balance Sheet
Leveraged recapitalization. A strategy to change the capital
structure of a firm by raising debt and reducing equity e.g.
borrowing funds to pay a large special dividend or doing a share
repurchase.

Question 2
ABC Industries is an all-equity firm operating in a perfect capital
market with 50 million shares outstanding that are trading for $4 per
share. ABC plans to carry out a leveraged recapitalization by
borrowing $80 million and using the funds to repurchase 20 million of
its outstanding shares.
The transaction can be viewed in two stages.
➀ Sell debt to raise $80 million in cash.
➁ Use the cash to repurchase shares.
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The Market Value Balance Sheet (Initial)

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The Market Value Balance Sheet (After Borrowing)

(1) Sell debt to raise $80 million in cash.

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The Market Value Balance Sheet (After Share
Repurchase)

(2) Use the cash to repurchase shares.

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 Part II

Modigliani-Miller Proposition II

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MM Proposition II without Taxes
MM Proposition II
The cost of capital of levered equity increases with the firm’s market
D
debt-to-equity ratio: rE = rU + (rU − rD )
E

From MM Proposition I (i.e. A = E + D = U), it follows that

the cash flows from unlevered equity can be replicated by
holding a portfolio of the firm’s debt and equity.

Since the return of a portfolio is equal to the weighted average

of the returns of its securities:
E D
rA = rE + rD = rU (2)
E +D E +D
rU is the firm’s unlevered cost of capital or pre-tax WACC. Since
there are no taxes in perfect capital markets, ru = rA = rWACC .
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Deriving MM Proposition II

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WACC and Leverage in Perfect Capital Markets

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Beta and Leverage in Perfect Capital Markets
The systematic risk of the assets of the firm (βA ) can also be
expressed as a weighted average of βE and βD .
E D
βA = βE + βD = βU
E +D E +D
When a firm changes its capital structure without changing its
investments, βA = βU will remain unaltered. However, its equity
beta will change due to the effect of leverage on the firm’s risk.

As the level of debt rises, the risk of the firm defaulting on its
debt increases. These costs are borne by the equity holders and
are reflected as follows:
D
βE = βU + (βU − βD ) (3)
E
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Reducing Leverage and the Cost of Capital

Question 3
Honeywell Inc. (HON) has a market debt-equity ratio of 0.5. Assume
that its current debt cost of capital is 6.5%, and its equity cost of
capital is 14%. If HON issues equity and uses the proceeds to repay
its debt and reduces its debt-equity ratio to 0.4, it will reduce its debt
cost of capital to 5.75%.

With perfect capital markets, what effect will this transaction

have on HON’s equity cost of capital and WACC?

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 Part III

Capital Structure Fallacies

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Capital Structure Fallacies

Fallacy 1
Since leverage increases EPS, it should also increase the firm’s stock
price.

Question 5
Levitron Industries (LVI) is an all-equity firm that expects to generate
$10 million of EBIT over the next year. Currently, it has 10 million
shares outstanding and its stock is trading at $7.50 per share. LVI is
considering changing its capital structure by borrowing $15 million at
an interest rate of 8% and using the proceeds to repurchase 2 million
shares at $7.50 per share. What happens to its EPS after
recapitalization?

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Workings
EPS without leverage:

Interest payment each year on new debt if LVI recapitalizes:

Expected earnings after interest payments:

EPS after recapitalization:

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EPS With and Without Leverage

Question 5 (Continued)
Suppose that EBIT is only $4 million.

What is the EPS without leverage?

What is the EPS with the new debt?

What is the EPS after recapitalization:

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EPS With and Without Leverage

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EPS With and Without Leverage

When earnings are low, leverage will cause the EPS to fall
further than it otherwise would have. If EBIT > $6 million, then
EPS is higher with leverage.

The steeper slope of EPS with Debt shows that leverage results
in EPS being more sensitive to changes in EBIT.

Also, while EPS increases on average, this increase is necessary

to compensate shareholders for the additional risk they are
taking, so LVI’s share price does not increase as a result of the
transaction.

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EPS With and Without Leverage

Question 5 (Continued)
Assume that LVI’s EBIT is not expected to grow in the future and
that all earnings are paid out as dividends. What is the value of its
shares after recapitalization?

Unlevered cost of equity, rU :

D/E ratio after recapitalization:

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Workings
Cost of equity (rE ) with leverage:

New value of its shares:

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Capital Structure Fallacies

Fallacy 2
Issuing equity will dilute shareholders’ ownership, so debt financing
should be used instead.

Proponents of this fallacy argue that the cash flows generated by

the firm must be divided among a larger number of shares when
the firm issues new shares, reducing (diluting) the value of each
individual share.

However, this reasoning ignores the fact that the cash raised by
issuing new shares will also increase the firm’s assets.

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Workings
Example 6
JSA has no debt and 500 million shares of stock outstanding trading
at a price of $16. Last month, the firm announced that it would
expand its operations by purchasing $1 billion of new planes. The
expansion will be financed by issuing new equity. How will the share
price change when the new equity is issued today?

Assets Before Equity Issue After Equity Issue

Cash
Existing Assets

Shares outstanding
(million)
Value per share
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Recap Session 1
Please indicate which TWO questions you would like covered
during the Recap Session in Practice Questions 1 and 2.

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 Part IV

Case Analysis

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Case Analysis

Objective. To analyze and present an assigned case based on

an actual company.

Scope of the Analysis

– Introductory overview and background
– Statement of the problem, objectives, key issues
– Available alternatives/options to consider
– Detailed analysis of alternatives/options
– Recommendations and Conclusion.
– Value-added material

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Case Analysis

Case Presentation. The duration of the presentation should be

between 30 and 45 minutes (including Q&A).

Deliverables. Presentation slides and a report that should not

exceed 1 page (double-sided), excluding appendices.

Deadline. Deliverables must be uploaded into

Assignments in eLearn by 6pm on the Monday before each
presentation. Peer evaluations to be submitted directly to the
TA at the same time.

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Peer Evaluation

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Peer Evaluation

For the case analysis, all students must submit a peer evaluation
of their team members.

– Scoring is from 0 to 10, with reasons needed for any score

below 7.

– Do not use more than one ”9” or ”10”. There are no

restrictions on the other marks you may give your team
members.

– Students with an average score exceeding 7, will be awarded

100% of the team’s final score. Those whose average score
is below 7, may receive a lower adjusted score.

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Suggested Readings

J. Berk. and P. DeMarzo.

Corporate Finance 6th Global Edition 2024, Pearson Education,
Chapter 14.

FNCE201 Corporate Finance

Practice Questions 2 (Capital Structure 1)

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