Capital Structure

1. Capital Structure Basic concepts: no taxes

2. Chapter 15 Capital Structure: Basic Concepts • Capital-structure and pie theory • No-arbitrage pricing. • Example: shares for debt • Value • Required return on the levered firm.

3. Financial Leverage, EPS, and ROE Current Proposed Assets $20,000 $20,000 Debt $0 $8,000 Equity $20,000 $12,000 Debt/Equity 0.00 0.67 Interest rate n/a 8% Shares 400 240 Share price $50 $50

4. Comments • Straight swap of equity for debt • Market prices unchanged • Real asset unchanged

5. Financial leverage and risk • Three states: bust, normal, boom. • Probabilities not explicit. • Look at each state separately.

6. EPS, ROE, Current Structure Shares Outstanding = 400 Bust Normal Boom 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%

7. EPS and ROE under Proposed Capital Structure Shares Outstanding = 240 Bust Normal Boom 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%

8. Find the point of equal EPS • For understanding the situation, not because it is a key to anything. • Let x = EBIT • Solve x/400 = (x - 640)/240 • Solution x = 1600. • EPS = 4 per share, in either structure

9. 12.00 Debt 10.00 Break-even Point 8.00 6.00 EPS 4.00 No Debt 2.00 0.00 EBIT 1,000 2,000 3,000 (2.00)

10. Modigliani-Miller (MM) Model • Perpetual Cash Flows (convenient) • Firms and investors can borrow and lend at the same rate (convenient) • Only value matters • No transaction costs (convenient) • No taxes

11. Homemade is a big concept • What financial managers do in the firm… • can be duplicated by investors in the market … • if they want to. • Implication: financial managers can’t raise value by restructuring.

12. Homemade leverage • Instead of the firm swapping equity for debt. • The investor does it himself, by borrowing. • It works out just as well.

13. Borrow $8000, buy the unlevered firm for $20,000 Bust Normal Boom Earnings $1000 $2000 $3000 Interest at 8% $640 $640 $640 Net Profits $360 $1360 $2360 ROE (on $12K) 3% 11% 20% Same as owning the levered firm

14. Okay, don’t buy the whole firm • Buy 10%, forty shares for $2000. • Borrow $800. • Total cost $1200 • Same as having 10% of the levered firm, that is, 24 shares at $50 per share.

15. Homemade annihilation of leverage • Idea. Form a portfolio. • Part lending… • part the levered firm. • Portfolio has the action of the unlevered firm. • A levered firm is a portfolio.

16. Buy the levered firm (240 shares) and lend 8000 Cost of Portfolio = 12000 + 8000 = 20000 Boom Normal Bust EPS $1.50 $5.67 $9.83 Earnings $360 $1360 $2360 Interest at (8%) $640 $640 $640 Net cash flow $1000 $2000 $3000 ROE 5% 10% 15% (Net cash flow / $2,000)

17. The firm is a veil • A way for shareholders to hold a portfolio.

18. The MM Propositions I & II (No Taxes) • P1: Value is unaffected by leverage • P1: VL = VU • P2: Leverage increases the risk and return to stockholders (formula to follow)

19. Proposition II of M-M • rB is the interest rate • rs is the return on (levered) equity • r0 is the return on unlevered equity • B is value of debt • SL is value of levered equity • rs = r0 + (B / SL) (r0 - rB)

20. Quick derivation of MM II • Uses MM I. Value unchanged. • Uses cash flow constraint.

21. MM I Cash

23. Cost of capital: r(%) rS . r0 rWACC rB Debt-to-equityratio (B/S) MM Proposition II no tax

24. Exam review • What is the weighted average cost of capital?

25. Answer • Don’t tell us a story. • Give the definitions and the formula. • rB = bond rate • rS = expected return on shares • B = market value of bonds • S = market value of shares • TC = corporate tax rate

26. Pay-off pitch • WACC =(S/(S+B))rS + (B/(S+B))(1-TC)rB