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Capital Structure

The document discusses capital structure and its impact on firm value according to the Modigliani-Miller (MM) theorems. The MM propositions state that with perfect markets and no taxes, capital structure does not affect firm value, but it can impact risk and required returns for stockholders. With corporate taxes, leverage can increase firm value up to the value of tax savings from interest expenses. Examples are provided to illustrate the MM propositions and how capital structure impacts stockholder returns and firm valuation.

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28 views15 pages

Capital Structure

The document discusses capital structure and its impact on firm value according to the Modigliani-Miller (MM) theorems. The MM propositions state that with perfect markets and no taxes, capital structure does not affect firm value, but it can impact risk and required returns for stockholders. With corporate taxes, leverage can increase firm value up to the value of tax savings from interest expenses. Examples are provided to illustrate the MM propositions and how capital structure impacts stockholder returns and firm valuation.

Uploaded by

makeyourcosmos
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Capital Structure

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.
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 primarily benefit the


stockholders if the value of the firm increases.
Financial Leverage, EPS, and ROE
• Consider an all-equity firm that is contemplating going into debt.
(Maybe some of the original shareholders want to cash out.)
EPS and ROE under Current Structure

Current Shares Outstanding = 400 shares


EPS and ROE under Proposed Structure

Proposed Shares Outstanding = 240 shares


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
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
MM Proposition II (No Taxes) – I
Proposition II
Leverage increases the risk and return to stockholders.
B
Rs = R0 + ×  R0  RB 
S

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 levered equity.
MM Proposition II (No Taxes) – II
B S
WACC = R0 = × RB + × RS
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 B B
× RB + RS = R0 × RB + RS = R0 + R0
S S S S
B
RS = R0 +  R0  RB 
S
MM Proposition II (No Taxes)
MM Propositions I & II (With Taxes)
Proposition I (with Corporate Taxes)
• Firm value increases with leverage.
VL = VU + TC 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   R 0 - R B 
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
Example 1
• Assume there are two firms, L and U, which are identical in all
respects except that firm L has 10 per cent, Rs 5,00,000 debentures.
The earnings before interest and taxes (EBIT) of both the firms are
equal, that is, Rs 1,00,000. The equity-capitalisation rate of firm L is
higher (16 per cent) than that of firm U (12.5 per cent).
Example 2
• The two companies X and Y belong to the same risk class. They have
everything in common except that firm Y has 10% debentures of Rs 5
lakh. The earnings before interest and taxes (EBIT) of both the firms
are equal, that is, Rs 7,50,000. The equity-capitalisation rate of firm X
is 12.5 per cent and that of firm U is 14 per cent. What are the values
of Firms X and Y.
An investor owns 10 per cent of the equity shares of the overvalued
firm. Determine his investment cost of earnings the same income so
that he is at a break-even point? Will he gain by investing in the
undervalued firm?
Example 3
• Devaki airlines is currently an unlevered firm. The company expects to
generate $150m in earnings before interest and taxes (EBIT) in
perpetuity. The corporate tax rate is 35 percent. All earnings after tax
are paid out as dividends.
The firm is considering a capital restructuring to allow $200m of debt.
Its cost of debt capital is 10%. Unlevered firms in the same industry
have a cost of capital of 20%. What will the new value of Devaki airlines
be?

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