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# Solvay Business School Universit Libre de Bruxelles

Andr Farber Revised May 2006

## Capital Structure and the Weighted Average Cost of Capital

MM 1958 Leverage and firm value MM I Required return to equityholders MM II: Beta Asset vs Beta Equity Weighted average cost of capital : V = VU rE = rA + (rA rD) (D/E) E = A + (A D ) (D/E) WACC = rE (E/V) + rD (D/V) WACC = rA VTS = TCD V = VU + TCD rE = rA + (rA rD) (1 TC) (D/E) E = [1+(1-TC)D/E] A WACC = rE (E/V) + rD (1-TC) (D/V) WACC = rA rA TC D/V V = VU + VTS rE = rA + (rA rD) (D/E) E = A + (A D ) (D/E) WACC = rE (E/V) + rD (1-TC) (D/V) WACC = rA rD TC D/V

Taxes - Constant riskless debt PV of tax shield: Value of levered firm (MM I): Required return to equityholders (MM II): Beta Asset vs Beta Equity Weighted average cost of capital Taxes Debt proportional to value L = D/V PV of tax shield: Value of levered firm (MM I): Required return to equityholders (MM II): Beta Asset vs Beta Equity Weighted average cost of capital

Taxes Variable debt: the Capital Cash Flows Approach (Ruback) Capital cash flow = Free cash flow unlevered + Tax shield Discount rate for capital cash flow = rA

## European Option Pricing (non dividend paying stock)

Payoffs at maturity: Call: max(0, ST K ) Put: max(0, K ST ) Put-Call Parity (European options on non dividend stocks): C + PV ( K ) = S + P Binomial option pricing model t length of time step risk-free interest rate / time step rf Underlying asset Derivative Gross returns in up and down states: Today S f u = e
t

Up uS fu 1 d = = e u

Down dS fd
t

Delta =

fu f d (uS dS )

## Risk neutral 1-period valuation formula: Risk-neutral probability of up:

f =
p=

pfu + (1 p) f d (1 + rf )
1 + rf d

ud (to calculate the true probability, replace rf by the expected return) State price: f = vu fu + vd f d p 1 p vu = vd = 1 + rf 1 + rf Black-Scholes formulas (European option on a stock paying a constant dividend yield q) Call option: C = Se qT N ( d1 ) Ke rT N (d 2 ) d1 = ln( Se qT ) Ke rT + 0.5 T T d2 = ln( Se qT ) Ke rT 0.5 T = d T 1 T

C S N(d2) = risk-neutral probability of exercising the call option Delta (Call ) = e qT N (d1 ) =

## Risky debt valuation

Merton model Market value of levered firm: V = VU Equity: Call option on the assets Debt: D = Risk-free debt Put option D = Risk-free debt PV(RNProba of default * RN expected loss given default) Beta asset vs beta equity: E = A DeltaEquity V / E Beta asset vs beta debt: Leland model Market value of levered firm: Value of \$1 if bankruptcy: PV of tax shield: PV of bankruptcy costs: Value of risky debt: Endogeneous level of bankruptcy:

D = A DeltaDebt V / D
V = VU + VTS - BC

VTS = [TC C / r ] (1 pB )
BC = pBVB D = (C / r )(1 pB ) + (1 )VB pB
VB = (1 TC )C /( r + 0.5 2 )

pB = (VB / VU ) 2

2r

## Warrants and convertible bonds

Warrants: Exercise if: q(VT + mK) > mK Value of warrant at maturity WT = (1-q)CT Zero-coupon bond with warrant / Convertible zero-coupon bond Exercise if: q(VT F + mK) > mK Value of warrant at maturity mWT = q Max(0,VT (nK+D)) Right issue Value of right: Right = [nnew/(nold+nnew)](Pcum Psub)