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# Chap016 capital structure

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### Chap016 capital structure

1. 1. Chapter 16 Capital Structure: Basic ConceptsMcGraw-Hill/Irwin Copyright © 2010 by the McGraw-Hill Companies, Inc. All rights reserved.  Understand the effect of financial leverage (i.e., capital structure) on firm earnings  Understand homemade leverage  Understand capital structure theories with and without taxes  Be able to compute the value of the unlevered and levered firm 16-1 16.1 The Capital Structure Question and The Pie Theory 16.2 Maximizing Firm Value versus Maximizing Stockholder Interests 16.3 Financial Leverage and Firm Value: An Example 16.4 Modigliani and Miller: Proposition II (No Taxes) 16.5 Taxes 16-2 1
2. 2.  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’smanagement is to make the S Bfirm as valuable as possible,then the firm should pick thedebt-equity ratio that makesthe pie as big as possible. Value of the Firm 16-3There are two important questions:1.Why should the stockholders care aboutmaximizing firm value? Perhaps they shouldbe interested in strategies that maximizeshareholder value.2.What is the ratio of debt-to-equity thatmaximizes the shareholder’s value?As it turns out, changes in capital structurebenefit the stockholders if and only if the valueof the firm increases. 16-4 Consider an all-equity firm that is contemplating going into debt. (Maybe some of the original shareholders want to cash out.) Current Proposed Assets \$20,000 \$20,000 Debt \$0 Equity \$20,000 \$8,000 Debt/Equity ratio 0.00 \$12,000 Interest rate n/a 2/3 Shares outstanding400 8% Share price \$50 240 \$50 16-5 2
3. 3. Recession Expected ExpansionEBIT \$1,000 \$2,000 \$3,000Interest 0 0 0Net income \$1,000 \$2,000 \$3,000EPS \$2.50 \$5.00 \$7.50ROA 5% 10% 15%ROE 5% 10% 15%Current Shares Outstanding = 400 shares 16-6 Recession Expected ExpansionEBIT \$1,000 \$2,000 \$3,000Interest 640 640 640Net income \$360 \$1,360 \$2,360EPS \$1.50 \$5.67 \$9.83ROA 1.8% 6.8% 11.8%ROE 3.0% 11.3% 19.7%Proposed Shares Outstanding = 240 shares 16-7 12.00 10.00 Debt 8.00 No Debt 6.00 Break-even AdvantageEPS point to debt 4.00 2.00 0.00 1,000 2,000 3,000 (2.00) Disadvantage EBIT in dollars, no taxes to debt 16-8 3
4. 4.  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 16-9 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) 3.0% 11.3% 19.7% We are buying 40 shares of a \$50 stock, using \$800 in margin. We get the same ROE as if we bought into a levered firm. B \$800 2 Our personal debt-equity ratio is: S \$1,200 3 16-10 RecessionExpected ExpansionEPS of Levered Firm \$1.50 \$5.67 \$9.83Earnings for 24 shares\$36 \$136 \$236Plus interest on \$800 (8%)\$64\$64 \$64Net Profits \$100 \$200 \$300ROE (Net Profits / \$2,000) 5% 10% 15%Buying 24 shares of an otherwise identical leveredfirm along with some of the firm’s debt gets us to theROE of the unlevered firm.This is the fundamental insight of M&M 16-11 4
5. 5.  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 16-12  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 16-13 The derivation is straightforward: B S RW ACC RB RS Then set RWACC R0 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 RB RS R0 S S B B B RB RS R0 R0 RS R0 ( R0 RB ) S S S 16-14 5
6. 6. Cost of capital: R (%) B RS R0 ( R0 RB ) SL B S R0 RW ACC RB RS B S B S RB RB Debt-to-equity Ratio B S 16-15 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) (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 16-16 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 16-17 6
7. 7. 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 ) S 16-18 Cost of capital: R B (%) RS R0 ( R0 RB ) SL B RS R0 (1 TC ) ( R0 RB ) SL R0 B SL RW ACC RB (1 TC ) RS B SL B SL RB Debt-to-equity ratio (B/S) 16-19 Recession Expected Expansion EBIT \$1,000 \$2,000 \$3,000 Interest 0 0 0All Equity 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 Recession Expected Expansion EBIT \$1,000 \$2,000 \$3,000 Interest (\$800 @ 8% ) 640 640 640 EBT \$360 \$1,360 \$2,360Levered Taxes (Tc = 35%) \$126 \$476 \$826 Total Cash Flow \$234+640 \$884+\$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 16-20 7
8. 8. All-equity firm Levered firm S G S G B 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. This is how cutting the pie differently can make the pie “larger.” -the government takes a smaller slice of the pie! 16-21 In a world of no taxes, the value of the firm is unaffected by capital structure. This is M&M Proposition I: V L = VU Proposition 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 16-22 In a world of taxes, but no bankruptcy costs, the value of the firm increases with leverage. This is M&M Proposition I: VL = V U + T C B Proposition 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 16-23 8
9. 9.  Why should stockholders care about maximizing firm value rather than just the value of the equity? How does financial leverage affect firm value without taxes? With taxes? What is homemade leverage? 16-24 9