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Chapter Fifteen
Capital Structure: Basic
Concepts
Corporate Finance
Ross Westerfield Jaffe

15
Sixth Edition

Prepared by
Gady Jacoby
University of Manitoba
and
Sebouh Aintablian
American University of
Beirut
McGraw-Hill Ryerson 2003 McGrawHill Ryerson Limited
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Chapter Outline

15.1 The Capital-Structure Question and The Pie Theory

15.2 Maximizing Firm Value versus Maximizing
Stockholder Interests
15.3 Financial Leverage and Firm Value: An Example
15.4 Modigliani and Miller: Proposition II (No Taxes)
15.5 Taxes
15.6 Summary and Conclusions

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15.1 The Capital-Structure Question and The Pie Theory

The value of a firm is defined to be the sum of the

value of the firms debt and the firms equity.
V=B+S

If the goal of the

management of the firm is to
S B
make the firm as valuable as
possible, then the firm should
pick the debt-equity ratio that
makes the pie as big as
possible.
Value of the Firm
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The Capital-Structure Question

There are really 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 shareholders value?

As it turns out, changes in capital structure benefit the

stockholders if and only if the value of the firm
increases.

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15.3 Financial Leverage, EPS, and ROE

Consider an all-equity firm that is considering going into

debt. (Maybe some of the original shareholders want to cash
out.)
Current Proposed
Assets $20,000 $20,000
Debt $0 $8,000
Equity $20,000 $12,000
Debt/Equity ratio 0.00 2/3
Interest rate n/a 8%
Shares outstanding 400 240
Share price $50 $50

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EPS and ROE Under Current Capital Structure

Recession Expected Expansion

EBIT $1,000 $2,000 $3,000
Interest 0 0 0
Net income $1,000 $2,000 $3,000
EPS $2.50 $5.00 $7.50
ROA 5% 10% 15%
ROE 5% 10% 15%

Current Shares Outstanding = 400 shares

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EPS and ROE Under Proposed Capital Structure

Recession Expected Expansion

EBIT $1,000 $2,000 $3,000
Interest 640 640 640
Net income $360 $1,360 $2,360
EPS $1.50 $5.67 $9.83
ROA 5% 10% 15%
ROE 3% 11% 20%

Proposed Shares Outstanding = 240 shares

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EPS and ROE Under Both Capital Structures

All-Equity
Recession Expected Expansion
EBIT $1,000 $2,000 $3,000
Interest 0 0 0
Net income $1,000 $2,000 $3,000
EPS $2.50 $5.00 $7.50
ROA 5% 10% 15%
ROE 5% 10% 15%
Current Shares Outstanding = 400 shares

Levered
Recession Expected Expansion
EBIT $1,000 $2,000 $3,000
Interest 640 640 640
Net income $360 $1,360 $2,360
EPS $1.50 $5.67 $9.83
ROA 5% 10% 15%
ROE 3% 11% 20%

Proposed Shares Outstanding = 240 shares

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15-8

Financial Leverage and EPS

12.00

10.00 Debt

8.00 No Debt

6.00 Break-even Advantage

EPS

point to debt
4.00

2.00

0.00
1,000 2,000 3,000
(2.00) Disadvantage
to debt EBIT
EBI in dollars, no taxes
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Assumptions of the Modigliani-Miller 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

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Homemade Leverage: An Example

Recession Expected Expansion
EPS of Unlevered Firm $2.50 $5.00 $7.50

Earnings for 40 shares $100 $200 $300

Less interest on $800 (8%) $64 $64 $64
Net Profits $36 $136 $236
ROE (Net Profits / $1,200) 3% 11% 20%

We are buying 40 shares of a $50 stock on margin. We get the

same ROE as if we bought into a levered firm.
Our personal debt equity ratio is: B $800
2
S $1,200 3
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Homemade (Un)Leverage: An Example

Recession Expected Expansion
EPS of Levered Firm $1.50 $5.67 $9.83

Earnings for 24 shares $36 $136 $236

Plus interest on $800 (8%) $64 $64 $64
Net profits $100 $200 $300
ROE (Net profits / $2,000) 5% 10% 15%

Buying 24 shares of an otherwise identical levered firm along

with some of the firms debt gets us to the ROE of the
unlevered firm.
This is the fundamental insight of M&M

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The MM Propositions I & II (No Taxes)

Proposition I
Firm value is not affected by leverage
VL = VU
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

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The MM Proposition I (No Taxes)

The derivation is straightforward:
Shareholde rs in a levered firm receive Bondholder s receive
EBIT rB B rB B
Thus, the total cash flow to all stakeholde rs is
( EBIT rB B) rB B
The present value of this stream of cash flows is VL
Clearly
( EBIT rB B) rB B EBIT
The present value of this stream of cash flows is VU

VL VU
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15.4 The MM Proposition II (No Taxes)

The derivation is straightforward:
B S
rW ACC rB rS Then set rWACC r0
BS BS
B S BS
rB rS r0 multiply both sides by
BS BS S
BS B BS S BS
rB rS r0
S BS S BS S
B BS
rB rS r0
S S

B B B
rB rS r0 r0 rS r0 (r0 rB )
S S S
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15-15 The Cost of Equity, the Cost of Debt, and the
Weighted Average Cost of Capital: MM
Proposition II with No Corporate Taxes
Cost of capital: r (%)

B
rS r0 (r0 rB )
SL

B S
r0 rW ACC rB rS
BS BS

rB rB

Debt-to-equity Ratio B
S
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15-16
15.5 Taxes
The MM Propositions I & II (with Corporate 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
interest tax shield
rS = r0 + (B/S)(1-TC)(r0 - rB)
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
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The MM Proposition I (Corp. Taxes)

Shareholde rs in a levered firm receive Bondholder s receive
( EBIT rB B) (1 TC ) rB B
Thus, the total cash flow to all stakeholde rs is
( EBIT rB B) (1 TC ) rB B
The present value of this stream of cash flows is VL
Clearly ( EBIT rB B) (1 TC ) rB B
EBIT (1 TC ) rB B (1 TC ) rB B
EBIT (1 TC ) rB B rB BTC rB B
The present value of the first term is VU
The present value of the second term is TCB
VL VU TC B
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15-18

The MM Proposition II (Corp. Taxes)

Start with M&M Proposition I with taxes: VL VU TC B
Since VL S B S B VU TC B
VU S B(1 TC )
The cash flows from each side of the balance sheet must equal:
SrS BrB VU r0 TC BrB
SrS BrB [S B(1 TC )]r0 TC rB B
Divide both sides by S
B B B
rS rB [1 (1 TC )]r0 TC rB
S S S
B
Which quickly reduces to rS r0 (1 TC ) (r0 rB )
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15-19
The Effect of Financial Leverage on the
Cost of Debt and Equity Capital
Cost of capital: r
(%)

B
rS r0 (1 TC ) (r0 rB )
SL

r0
B SL
rW ACC rB (1 TC ) rS
BSL B SL
rB

Debt-to-equity
ratio (B/S)

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15-20
Total Cash Flow to Investors Under
Each Capital Structure with Corp. Taxes
All-Equity
Recession Expected Expansion
EBIT $1,000 $2,000 $3,000
Interest 0 0 0
EBT $1,000 $2,000 $3,000
Taxes (Tc = 35% $350 $700 $1,050

Total Cash Flow to S/H $650 $1,300 $1,950

Levered
Recession Expected Expansion
EBIT $1,000 $2,000 $3,000
Interest ($800 @ 8% ) 640 640 640
EBT $360 $1,360 $2,360
Taxes (Tc = 35%) $126 $476 $826
Total Cash Flow $234+640 $468+$640 $1,534+$640
(to both S/H & B/H): $874 $1,524 $2,174
EBIT(1-Tc)+TCrBB $650+$224 $1,300+$224 $1,950+$224
$874 $1,524 $2,174
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15-21
Total Cash Flow to Investors Under
Each Capital Structure with Corp. Taxes

All-equity firm Levered firm

S G S G

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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15-22

Summary: No Taxes
In a world of no taxes, the value of the firm is unaffected by
capital structure.
This is M&M Proposition I:
VL = VU
Prop I holds because shareholders can achieve any pattern of
payouts they desire with homemade leverage.

In a world of no taxes, M&M Proposition II states that

leverage increases the risk and return to stockholders

B
rS r0 (r0 rB )
SL

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15-23

Summary: Taxes
In a world of taxes, but no bankruptcy costs, the value of the
firm increases with leverage.
This is M&M Proposition I:
VL = VU + TC B
Prop I holds because shareholders can achieve any pattern of
payouts they desire with homemade leverage.

In a world of taxes, M&M Proposition II states that leverage

increases the risk and return to stockholders.

B
rS r0 (1 TC ) (r0 rB )
SL

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Prospectus: Bankruptcy Costs

So far, we have seen M&M suggest that financial
leverage does not matter, or imply that taxes cause
the optimal financial structure to be 100% debt.
In the real world, most executives do not like a
capital structure of 100% debt because that is a state
known as bankruptcy.
In the next chapter we will introduce the notion of a
limit on the use of debt: financial distress.
Use this chapter to get comfortable with M&M
algebra.

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