Capital Structure and Long-term Financing RWJ Chp 15

1. Capital Structure and Long-term FinancingRWJ Chp 15

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

3. The Capital-Structure Question There are really two important questions: • Why should the stockholders care about maximizing firm value? Perhaps they should be interested in strategies that maximize shareholder value. • What is the ratio of debt-to-equity that maximizes the shareholder’s value? As it turns out, changes in capital structure benefit the stockholders if and only if the value of the firm increases.

4. 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 Assets RM20,000 Debt RM0 Equity RM20,000 Debt/Equity ratio 0.00 Interest rate n/a Shares outstanding 400 Share price RM50 Proposed RM20,000 RM8,000 RM12,000 2/3 8% 240 RM50

5. EPS and ROE Under Current Capital Structure Recession Expected Expansion EBIT RM1,000 RM2,000 RM3,000 Interest 0 0 0 Net income RM1,000 RM2,000 RM3,000 EPS RM2.50 RM5.00 RM7.50 ROA 5% 10% 15% ROE 5% 10% 15% Current Shares Outstanding = 400 shares

6. EPS and ROE Under Proposed Capital Structure Recession Expected Expansion EBIT RM1,000 RM2,000 RM3,000 Interest 640 640 640 Net income RM360 RM1,360 RM2,360 EPS RM1.50 RM5.67 RM9.83 ROA 5% 10% 15% ROE 3% 11% 20% Proposed Shares Outstanding = 240 shares

7. EPS and ROE Under Both Capital Structures All-Equity Recession Expected Expansion EBIT RM1,000 RM2,000 RM3,000 Interest 0 0 0 Net income RM1,000 RM2,000 RM3,000 EPS RM2.50 RM5.00 RM7.50 ROA 5% 10% 15% ROE 5% 10% 15% Current Shares Outstanding = 400 shares Levered Recession Expected Expansion EBIT RM1,000 RM2,000 RM3,000 Interest 640 640 640 Net income RM360 RM1,360 RM2,360 EPS RM1.50 RM5.67 RM9.83 ROA 5% 10% 15% ROE 3% 11% 20% Proposed Shares Outstanding = 240 shares

8. Financial Leverage and EPS 12.00 Debt 10.00 8.00 No Debt Advantage to debt 6.00 Break-even point EPS 4.00 2.00 0.00 1,000 2,000 3,000 Disadvantage to debt (2.00) EBIT EBI in dollars, no taxes

9. 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

10. Homemade Leverage: An Example Recession Expected Expansion EPS of Unlevered Firm RM2.50 RM5.00 RM7.50 Earnings for 40 shares RM100 RM200 RM300 Less interest on RM800 (8%) RM64 RM64 RM64 Net Profits RM36 RM136 RM236 ROE (Net Profits / RM1,200) 3% 11% 20% We are buying 40 shares of a RM50 stock on margin. We get the same ROE as if we bought into a levered firm. Our personal debt equity ratio is:

11. Homemade (Un)Leverage: An Example Recession Expected Expansion EPS of Levered Firm RM1.50 RM5.67 RM9.83 Earnings for 24 shares RM36 RM136 RM236 Plus interest on RM800 (8%) RM64 RM64 RM64 Net Profits RM100 RM200 RM300 ROE (Net Profits / RM2,000) 5% 10% 15% Buying 24 shares of an other-wise identical levered firm along with the some of the firm’s debt gets us to the ROE of the unlevered firm. This is the fundamental insight of M&M

12. 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

13. The MM Proposition I (No Taxes) The derivation is straightforward: The present value of this stream of cash flows is VL The present value of this stream of cash flows is VU

14. The MM Proposition II (No Taxes) The derivation is straightforward:

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 (%) r0 rB rB Debt-to-equity Ratio

16. 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

17. The MM Proposition I (Corp. Taxes) The present value of this stream of cash flows is VL The present value of the first term is VU The present value of the second term is TCB

18. The MM Proposition II (Corp. Taxes) Start with M&M Proposition I with taxes: Since The cash flows from each side of the balance sheet must equal: Divide both sides by S Which quickly reduces to

19. The Effect of Financial Leverage on the Cost of Debt and Equity Capital Cost of capital: r(%) r0 rB Debt-to-equityratio (B/S)

20. Total Cash Flow to Investors Under Each Capital Structure with Corp. Taxes All-EquityRecession Expected Expansion EBIT RM1,000 RM2,000 RM3,000 Interest 0 0 0 EBT RM1,000 RM2,000 RM3,000 Taxes (Tc = 35% RM350 RM700 RM1,050 Total Cash Flow to S/H RM650 RM1,300 RM1,950 Levered Recession Expected Expansion EBIT RM1,000 RM2,000 RM3,000 Interest (RM800 @ 8% ) 640 640 640 EBT RM360 RM1,360 RM2,360 Taxes (Tc = 35%) RM126 RM476 RM826 Total Cash Flow RM234+640 RM468+RM640 RM1,534+RM640 (to both S/H & B/H): RM874 RM1,524 RM2,174 EBIT(1-Tc)+TCrBB RM650+RM224 RM1,300+RM224 RM1,950+RM224 RM874 RM1,524 RM2,174

21. Total Cash Flow to Investors Under Each Capital Structure with Corp. Taxes 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.

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

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.

24. 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. • The important use of this chapter is to get comfortable with “M&M algebra”.