Chapter 14

Capital Structure
in a Perfect Market

Chapter Outline
14.1 Equity versus Debt Financing
14.2 Modigliani-Miller I: Leverage, Arbitrage, and Firm
Value
14.3 Modigliani-Miller II: Leverage, Risk, and the Cost
of Capital
14.4 Capital Structure Fallacies
14.5 MM: Beyond the Propositions

Learning Objectives
1. Define the types of securities usually used by

firms to raise capital; define leverage.

2. Describe the capital structure that the firm

should choose.
3. List the three conditions that make capital

markets perfect.
4. Discuss the implications of MM Proposition I, and

the roles of homemade leverage and the Law of

One Price in the development of the proposition.

Learning Objectives
(cont'd)
5. Calculate the cost of capital for levered equity

according to MM Proposition II.

6. Illustrate the effect of a change in debt on

weighted average cost of capital in perfect

capital markets.
7. Calculate the market risk of a firms assets using

its unlevered beta.

8. Illustrate the effect of increased leverage on the

beta of a firms equity.

Learning Objectives
(cont'd)
9. Compute a firms net debt.
10. Discuss the effect of leverage on a firms

expected earnings per share.

11. Show the effect of dilution on equity value.
12. Explain why perfect capital markets neither

create nor destroy value.

Why capital structure

matters?
Balance Sheet
Assets

Liabilities & Equity

-The role of financial markets

14.1 Equity Versus Debt Financing

Capital Structure
The relative proportions of debt, equity, and other

securities that a firm has outstanding

A mix of a company's long-termdebt, specific short-term

debt, common equity and preferred equity. The capital

structure ishow a firm finances its overall operations and
growth byusing different sources of funds.
______ comes in the form of bond issues or long-term notes

payable,
while ________is classified as common stock, preferred

stock or retained earnings.

Equity and Debt

Firms may choose to raise capital via:
Equity only;
Equity and Debt.

Financing a Firm with

Equity
You are considering an investment
opportunity.
For an initial investment of $800 this year, the

project will generate cash flows of either $1400

or $900 next year, depending on whether the
economy is strong or weak, respectively. Both
scenarios are equally likely.

Table 14.1 The Project Cash Flows

You are considering an investment
opportunity.
For an initial investment of $800 this year, the project will
generate cash flows of either $1400 or $900 next year,
depending on whether the economy is strong or weak,
respectively. Both scenarios are equally likely.

10

Financing a Firm with Equity

(cont'd)
The project cash flows depend on the overall

economy and thus contain _______ risk. As a

result, you demand a 10% risk premium over
the current risk-free interest rate of 5% to
invest in this project.
What is the NPV of this investment

opportunity?

11

Financing a Firm with Equity

(cont'd)
The cost of capital for this project is 15%. The

expected cash flow in one year is:

(0.5)($1400) + (0.5)(

) = $1150.

The NPV of the project is:

$1150
NPV $800
$800 $1000 $200
1.15

12

Financing a Firm with Equity

(cont'd)
If you finance this project using only equity,

how much would you be willing to pay for the

project?

$1150
PV (equity cash flows)
$1000
1.15

If you can raise $1000 by selling equity in the firm,

after paying the investment cost of $800, you can
keep the remaining $200, the NPV of the project NPV,
as a profit.

13

Financing a Firm with Equity (cont'd)

Unlevered Equity
Equity in a firm with no debt

Because there is no debt, the cash flows of

the unlevered equity are equal to those of the

project.

14

Table 14.2 Cash Flows and Returns

for Unlevered Equity

15

Financing a Firm with Equity (cont'd)

Shareholders returns are either 40% or 10%.
The expected return on the unlevered equity is:

(0.5)(40%) + (0.5)(10%) = 15%.

Because the cost of capital of the project is 15%,

shareholders are earning an appropriate return for
the risk they are taking.

16

Financing a Firm with Debt and Equity

Suppose you decide to borrow $500 initially, in

addition to selling equity.

Because the projects cash flow will always be

enough to repay the debt, the debt is risk free and

you can borrow at the risk-free interest rate of 5%.
You will owe the debt holders:

$500 1.05 = $525 in one year.

Levered Equity
Equity in a firm that also has ____ outstanding
Promised payments to debt holders must be made
before any payments to equity holders are
distributed.
17

Financing a Firm
with Debt and Equity (cont'd)
Given the firms $525 debt obligation, your

shareholders will receive only $875 ($1400

$525) if the economy is strong, and $375 ($900
$525) if the economy is weak.

18

Table 14.3 Values and Cash Flows for

Debt and Equity of the Levered Firm

19

Financing a Firm
with Debt and Equity (cont'd)
What

Price E should the levered equity sell

for?
Which is the best

capital structure choice

for the entrepreneur?

20

Financing a Firm
with Debt and Equity (cont'd)
Modigliani and Miller argued that with perfect

capital markets, the total value of a firm

should depend on its capital structure.
They reasoned that the firms total cash flows

still equal the cash flows of the project, and

therefore have the same present value.

21

The Value of the Firm

The ______ of the firm is determined by the profitability (NOI) &

business risk, NOT capital structure.

Financing a Firm
with Debt and Equity (cont'd)
Because the cash flows of the debt and equity

sum to the cash flows of the project, by the

Law of One Price the combined values of debt
and equity must be $1000.
Therefore, if the value of the debt is $500, the

value of the levered equity must be $500.

E = $1000 $500 = $500.

23

Financing a Firm
with Debt and Equity (cont'd)
Because the cash flows of levered equity

are smaller than those of unlevered equity,

levered equity will be at a lower price ($500
versus $1000).
However, you are not worse off. You will still raise

a total of $1000 by issuing both debt and levered

equity. Consequently, you would be indifferent
between these two choices for the firms capital
structure.

24

The Effect of Leverage on Risk and

Return
Leverage increases the ______ of the equity of a

firm.
Therefore, it is inappropriate to discount the cash

flows of levered equity at the same discount rate

of 15% that you used for unlevered equity.
Investors in levered equity will require a _________
required return to compensate for the increased
risk.
A higher or lower discount rate to reflect

increasing risk?

25

Table 14.4 Returns to Equity with

and without Leverage

26

Table 14.4 Returns to Equity with

and without Leverage

Returns
Expected return

Unlevered
Equity

Levered Equity

40% or -10%

75% or -25%

15%

25%

27

The Effect of Leverage on Risk and

Return (cont'd)
The returns to equity holders are very different

with and without leverage.

Unlevered equity has a return of either 40% or

10%, for an expected return of 15%.

Levered equity has higher risk, with a return of

either 75% or 25%.

To compensate for this risk, levered equity holders

receive a higher expected return of 25%.

28

The Effect of Leverage

on Risk and Return (cont'd)
The relationship between risk and return can

be evaluated more formally by computing the

sensitivity of each securitys return to the
systematic risk of the economy.

29

Table 14.5 Systematic Risk and Risk Premiums

for Debt, Unlevered Equity, and Levered Equity

Risk-free rate: 5%;

Since levered equity has _____ the
systematic risk of unlevered
equity, its risk premium is ______
of the unlevered equity.

30

The Effect of Leverage

on Risk and Return (cont'd)
Because the debts return bears ____

systematic risk, its risk premium is zero. Why?

31

The Effect of Leverage

on Risk and Return (cont'd)
In summary:
In the case of perfect capital markets, if the

firm is 100% equity financed, the equity holders

will require a 15% expected return.
If the firm is financed 50% with debt and 50%

with equity, the debt holders will receive a

return of 5%, while the levered equity holders
will require an expected return of 25% (because
of their increased risk).

32

The Effect of Leverage

on Risk and Return (cont'd)
In summary:
Leverage increases the risk of ________ even

when there is no risk that the firm will default.

Thus, while debt may be cheaper, its use raises the

cost of capital for equity. Considering both sources
of capital together, the firms average cost of capital
with leverage is the same as for the unlevered firm:
(0.5)5%+(0.5)25%=15%.

33

Textbook Example 14.1

34

Textbook Example 14.1

(cont'd)

Unlevered equity:
(1400/1000)-1=40%;
(900/1000)-1=-10%
Return sensitivity: 50%;
Risk premium: 15%5%=10%

35

14.2 Modigliani-Miller I: Leverage,

Arbitrage, and Firm Value
The Law of One Price implies that leverage

will _____ affect the total value of the firm.

Instead, it merely changes the allocation of

cash flows between debt and equity, without

altering the total cash flows of the firm.

36

14.2 Modigliani-Miller I: Leverage,

Arbitrage, and Firm Value (cont'd)
Modigliani and Miller (MM) showed that this result

holds more generally under a set of conditions

referred to as perfect capital markets:
Investors and firms can trade the same set of securities

at competitive market prices equal to the present value

of their future cash flows.
There are no taxes, transaction costs, or issuance costs

associated with security trading.

A firms financing decisions do not change the cash flows

generated by its investments, nor do they reveal new

information about them.

37

14.2 Modigliani-Miller I: Leverage,

Arbitrage, and Firm Value (cont'd)
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 _____
affected by its choice of capital structure.

38

MM and the Law of One

Price
MM established their result with the

following argument:
In the absence of taxes or other transaction

costs, the total cash flow paid out to all of a

firms security holders is equal to the total cash
flow generated by the firms assets.

Therefore, by the Law of One Price, the firms

securities and its assets must have the same total
market value.

39

Homemade Leverage
Homemade Leverage
When investors use leverage in their own

portfolios to adjust the leverage choice made

by the firm.
Used as a substitute for the use of leverage by

the firm.

MM demonstrated that if investors would

prefer an alternative capital structure to the

one the firm has chosen, investors can borrow
or lend on their own (assume at the same rate
as the firm) and achieve the same result.
40

Homemade Leverage
(cont'd)
Assume you use no leverage and create an

all-equity firm.
An investor who would prefer to hold levered

equity can do so by using leverage in his own

portfolio.

41

14.3 Modigliani-Miller II: Leverage,

Risk, and the Cost of Capital

If the firm can borrow at the risk-free rate,

isnt debt a cheaper and better source of
capital than equity?

42

14.3 Modigliani-Miller II: Leverage,

Risk, and the Cost of Capital
If the firm can borrow at the risk-free rate, isnt debt
a cheaper and better source of capital than equity?
-Although debt does have a lower cost of capital than
equity, the cost cannot be considered in isolation.
-Debt increases the risk and therefore the cost of
capital of the firms equity.
-Leverage increases EPS (due to higher risk),
shareholders will demand a higher return.
-In the end, the savings from the low expected return
on debt are exactly offset by a higher cost of equity,
and hence no net savings for the firm.

43

14.3 Modigliani-Miller II: Leverage,

Risk, and the Cost of Capital
Leverage and the Equity Cost of Capital
MMs first proposition can be used to derive an

explicit relationship between leverage and the

equity cost of capital.

44

14.3 Modigliani-Miller II: Leverage, Risk,

and the Cost of Capital (cont'd)
Leverage and the Equity Cost of Capital
E

Market value of equity in a levered firm.

Market value of debt in a levered firm.

Market value of equity in an unlevered firm.

Market value of the firms assets.

45

14.3 Modigliani-Miller II: Leverage, Risk,

and the Cost of Capital (cont'd)
Leverage and the Equity Cost of Capital
MM Proposition I states that:

E D U A

The total market value of the firms securities is

equal to the market value of its assets, whether the
firm is unlevered or levered.

46

14.3 Modigliani-Miller II: Leverage, Risk,

and the Cost of Capital (cont'd)
Leverage and the Equity Cost of Capital
The cash flows from holding unlevered equity

can be _________ using homemade leverage by

holding a portfolio of the firms equity and debt.

47

14.3 Modigliani-Miller II: Leverage, Risk,

and the Cost of Capital (cont'd)
Leverage and the Equity Cost of Capital
The return on unlevered equity (RU) is related to

the returns of levered equity (RE) and debt (RD):

E
D
RE
RD RU
E D
E D

48

14.3 Modigliani-Miller II: Leverage, Risk,

and the Cost of Capital (cont'd)
Leverage and the Equity Cost of Capital
Solving for RE:

RE

RU
( RU RD )
{
E 44 2 4 43
1
Risk without
leverage

Additional risk
due to leverage

The levered equity return equals the unlevered

return, plus a premium due to leverage.
The

amount of the premium depends on the amount

of leverage, measured by the firms market value
debt-equity ratio, D/E.

49

14.3 Modigliani-Miller II: Leverage, Risk,

and the Cost of Capital (cont'd)
Leverage and the Equity Cost of Capital
MM Proposition II:

The cost of capital of levered equity is equal to the

cost of capital of unlevered equity plus a premium
that is proportional to the market value debt-equity
ratio.

Cost of Capital of Levered Equity

rE

D
rU
( rU rD )
E
50

14.3 Modigliani-Miller II: Leverage, Risk,

and the Cost of Capital (cont'd)
Leverage and the Equity Cost of Capital
Recall from above:

If the firm is all-equity financed, the expected return

on unlevered equity is 15%.

If the firm is financed with $500 of debt, the

expected return of the debt is 5%.

51

14.3 Modigliani-Miller II: Leverage, Risk,

and the Cost of Capital (cont'd)
Leverage and the Equity Cost of Capital
Therefore, according to MM Proposition II, the

expected return on equity for the levered firm

is:

rE

500
15%
(15% 5%) 25%
500

52

Textbook Example 14.4

53

Textbook Example 14.4 (cont'd)

54

Capital Budgeting and the

Weighted Average Cost of Capital
If a firm is unlevered, all of the free cash flows

generated by its assets are paid out to its

equity holders.
The market value, risk, and cost of capital for

the firms assets and its equity coincide and,

therefore:

rU rA

55

Capital Budgeting and the Weighted

Average Cost of Capital (cont'd)
If a firm is levered, project rA is equal to the

firms weighted average cost of capital.

Unlevered Cost of Capital (pretax WACC)
Equity
Fraction of Firm Value
Fraction of Firm Value

Financed by Debt
Financed by Equity Cost of Capital

E
D

rE
rD
E D
E D

rwacc

Debt

Cost of Capital

rwacc rU rA
56

Capital Budgeting and the Weighted

Average Cost of Capital (cont'd)
With perfect capital markets, a firms WACC is

independent of its capital structure and is

equal to its equity cost of capital if it is
unlevered, which matches the cost of capital
of its assets: rWACC=Ko=Ke
Debt-to-Value Ratio
The fraction of a firms enterprise value that

corresponds to debt.

57

Capital Budgeting and the Weighted

Average Cost of Capital (cont'd)
With no debt, the WACC is equal to the

unlevered equity cost of capital.

As the firm borrows at the low cost of capital

for debt, its equity cost of capital _____. The

net effect is that the firms WACC is _________.

58

Textbook Example 14.5

59

Textbook Example 14.5

(cont'd)

60

Why is capital structure important?

Leverage
Higher financial leverage means potentially higher
returns to shareholders, but higher risk
(financial distress) due to higher interest payments

Cost of capital
Each source of finance has a different cost. Capital
structure affects the cost of capital

Optimal capital structure

The structure that minimises the firms cost of capital
and maximises firm value (shareholders wealth)

The Use of Debt

Essentially,
the change of financing mix (capital structure)
lower Ko and higher Po
Where, debt

= interest exp.
= tax shield
= shareholders wealth

Conclusion?
Can/should a company maximise its share
price and shareholders wealth by having a
capital structure of 99.9% of

Why not 100% debt?

Costs associated with financial distress (can outweigh
tax shield adv.)
Financing becomes difficult to obtain
Customers leave due to uncertainty
Possible restructuring or liquidation costs if bankruptcy

(pressured by creditors) occurs

Debtors seize control
Equity is wiped out, and
The firm collapse

Agency costs (costs to protect debt-holders)

Managers act on behalf of shareholders not debt-holders:

potential conflict of interest (conflict betw. Shareholders &

debt holders).
Debt covenant costs: managers need monitoring

So
Too much debt id BAD!!!

65

In Reality

Moderate
position

Moderate position

Interest expenses are allowable tax

deductions
Tax deductible interest is called the tax
shield
Results in the cost of debt finance being even

cheaper than the cost of debt in both extreme

positions

However, the probability that a firm will fail

increases with the level of financial leverage

Therefore: liquidation costs become important

Capital structure management in

practice
Decisions are more complex than indicated in
the moderate view because:
Firms tend to maintain spare debt capacity
No distinction between internal and external funds
Short -to medium-term borrowing is preferred to

longer-term borrowing
Timing of equity and debt issues based on market
conditions is a key consideration
Family-controlled companies are concerned with
diluting ownership

Pecking order theory

Investment opportunities tend to drive a

companys dividend policy

Order of financing:
Internally generated funds
Issue of debt securities
Issue of convertible securities
Issue of equity securities

Implication:
Observed leverage ratios will reflect the cumulative

financing needs of companies over time