SESSION 19

Key Concepts and Skills

• 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

Chapter outline:
- The Capital Structure Question and The Pie Theory
- Maximizing Firm Value versus Maximizing Stockholder Interests
- Financial Leverage and Firm Value: An Example
- Taxes

I. CAPITAL STRUCTURE

A key decision for any company is to define how much it will be funded by equity and how much
by debt.

For the most part, a firm can choose any capital structure that it wants. If management so
desired, a firm could issue some bonds and use the proceeds to buy back some stock, thereby
increasing the debt-equity ratio. Alternatively, it could issue stock and use the money to pay off
some debt, thereby reducing the debt-equity ratio.

Because the assets of a firm are not directly affected by a capital restructuring, we can examine
the firm’s capital structure decision separately from its other activities. This means that a firm
can consider capital restructuring decisions in isolation from its investment decisions.

EV Enterprise Value:

Balance Sheet Model of the Firm

CAPITAL STRUCTURE AND THE PIE

The value of a firm is defined to be the

sum of the value of the firm’s debt and
the firm’s equity (the liability side of
the balanced sheet). V = B + S

II. STOCKHOLDER INTERESTS

There are two important questions:
1. Why should the stockholders care about maximizing firm value? Perhaps they should be
interested in strategies that maximize shareholder value only?
2. What is the ratio of debt-to-equity that maximizes the shareholder’s value?

• We will study the impact of leverage in terms of its effects on earnings per share, EPS, and
return on equity, ROE.
• As it turns out, changes in capital structure benefit the stockholders if and only if the value
of the firm increases.

1
 SESSION 19

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.) Money is borrowed to buy back shares and thus change the
equity/debt ratio.

EPS and ROE Under Current Structure

Ex.1. Try to do the same but for the leveraged company.

EPS and ROE Under Proposed Leveraged Structure (solution)

FINAL RESULT: Financial Leverage and EPS

Financial leverage acts to magnify gains and losses to shareholders.

The breakeven point is when the ROE coincides with the

interest rate. You see why?

Exc2: The MPD Corporation has decided in favor of a capital restructuring. Currently, MPD
uses no debt financing. Following the restructuring, however, debt will be $1 million. The
interest rate on the debt will be 9 percent. MPD currently has 200,000 shares outstanding, and
the price per share is $20. If the restructuring is expected to increase EPS, what is the minimum
level for EBIT that MPD’s management must be expecting? Ignore taxes in answering

2
 SESSION 19

To answer, we calculate the break-even EBIT that will give the same EPS. At any EBIT above this, the increased
financial leverage will increase EPS, so this will tell us the minimum level for EBIT. Under the old capital structure,
EPS is simply EBIT/200,000. Under the new capital structure, the interest expense will be $1 million .09 $90,000.
Furthermore, with the $1 million proceeds, MPD will repurchase $1 million/20 50,000 shares of stock, leaving
150,000 outstanding. EPS will thus be (EBIT - $90,000)/150,000.
Now that we know how to calculate EPS under both scenarios, we set them equal to each other and solve for the
break-even EBIT: EBIT/200,000 = (EBIT - $90,000)/150,000
EBIT = 4/3 (EBIT - $90,000)
EBIT = $360,000
Verify that, in either case, EPS is $1.80 when EBIT is $360,000. Management at MPD is apparently of the opinion
that EBIT will exceed $360,000 and therefore EPS will exceed $1.80

MODIGLIANI- MILLER THEOREM

• The Modigliani-Miller theorem (named after Franco Modigliani and Merton Miller) is an
essential part of modern academic thinking about the financial structure of the firm.
• The theorem states that the value of a company is not affected by the way it is financed in
the absence of taxes, bankruptcy costs and asymmetries in agent information. The theorem
states that it is immaterial whether a company achieves the financial resources necessary
for its operation by going to its shareholders or issuing debt. The dividend policy is also
indifferent. It is thus opposed to the traditional point of view.
• To understand it intuitively it states that shareholders
can borrow money to buy shares so the company
doing this does not make them any better or worse.
• The key question is: are these two companies worth
the same?

HOMEMADE LEVERAGE
- Basically it gives the same return to borrow half the money required to buy shares in an
unleveraged company than to invest directly in a company that that 50% funded by debt.
- Keep in mind that in the real world the actual cost of borrowing will not be the same but the
concept is useful when analyzing the benefits of a company borrowing.

Assumptions of the M&M Model

But to hold it needs some strong assumptions:
• 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

MODIGLIANI AND MILLER: PROPOSITION II (NO TAXES)

• 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
• Proposition II (No taxes)
• Leverage increases the risk and return to stockholders

3
 SESSION 19

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

The derivation is straightforward from the WACC calculation (solo aprender la última fórmula)

As the firm raises its debt-equity ratio, the

increase in leverage raises the risk of the equity
and therefore the required return or cost of
equity.

GRAFICA- There is a relation segun aumenta deuda

tienes mas beneficios porq no pagas tax.

• Notice in the previous figure that the WACC doesn’t depend on the debt-equity ratio;
it’s the same no matter what the debt-equity ratio is. This is another way of stating M&M
Proposition I: the firm’s overall cost of capital is unaffected by its capital structure.

• As illustrated, the fact that the cost of debt is lower than the cost of equity is exactly
offset by the increase in the cost of equity from borrowing. In other words, the change
in the capital structure weights is exactly offset by the change in the cost of equity, so
the WACC stays the same. This is the idea you have to learn.

2 KEY IDEAS:
• First, if a company makes money from its operations it can pay a dividend and pay taxes or
repay debt and not pay taxes. Interest paid on debt is tax deductible. This is good for the
firm, and it may be an added benefit of debt financing.
• Second, failure to meet debt obligations can result in bankruptcy which is bad, while equity
does not have to be paid back.
• In other words dividends pay taxes, paying back debt does not pay taxes so the later has an
advantage but involves more risk for the shareholders as in case of bankruptcy they only get
paid after all debt is paid. THESE ARE TWO OPPOSING FORCES – YOU NEED TO FIND THE
OPTIMUM POINT
MM Propositions I & II (With Taxes)
Proposition I (with Corporate Taxes)

4
 SESSION 19

• Firm value increases with leverage

VL = VU + TC B MEMORIZE THIS!

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) No need to memorize
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

MM Proposition I (With Taxes)

• Si el profit va al shareholder pagas taxes, si el profit es hecho con debt no pagas taxes
• Formula importante- Rb es interest y b es la deuda del bank

- Primera formula es el flow de los stakeholders= (ebit-RbB)*(1-Tc)+RbB

- RbB es el value of the organization- equity + debt
- El valor d una organización no es solo shareholders equity, el debt tb da valor a una compañía

MM Proposition II (With Taxes)

5
 SESSION 19

The Effect of Financial Leverage

Do not worry too much about the

formulas but you must understand the
concept that taxes improve the WACC
of the company if the company
borrows more money

Total Cash Flow to Investors

The difference is the difference in

taxes

But if you consider that shares

have gone from 400 to 240 you
will see that in terms of EPS which
is what matters to shareholders
they are better off in two of the
three scenarios.

So debt overall increases

shareholder value although it does
increase volatility of returns.

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.” or what is the same:the government takes a
smaller slice of the pie!
GRFAICA CON DOS CIRCULOS- Company value is based only en lo que te quita el gobierno, por eso aunq
shareholders tengan menos y haya debt, como el gobierno no quita taxes la compañía vale mas.

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
• Proposition I holds because shareholders can achieve any pattern B
RS = R0 +  ( R0 − RB )
of payouts they desire with homemade leverage. SL
• In a world of no taxes, M&M Proposition II states that leverage
increases the risk and return to stockholders.

6
 SESSION 19

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
• 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.

Sin RbB son compañías que no tienen debt y Tc son taxes B

Vl value of leverage company= value of unanleverage + taxes for debt
RS = R0 +  (1 − TC )  ( R0 − RB )
SL

QUICK QUESTION:
Should stockholders care about maximizing firm value or just the value of the equity?
No right answer, in principle shareholders will only care about the value of the equity but this sometimes
becomes too short term and runs the risk of killing the golden goose.

CAPITAL STRUCTURE: LIMITS TO THE USE OF DEBT

BANKRUPTCY COSTS:

• One limiting factor affecting the amount of debt a firm might use comes in the form of
bankruptcy costs. As the debt-equity ratio rises, so too does the probability that the firm
will be unable to pay its bondholders what was promised to them. When this happens,
ownership of the firm’s assets is ultimately transferred from the stockholders to the
bondholders.

• When the value of a firm’s assets equals the value of its debt, then the firm is
economically bankrupt in the sense that the equity has no value. However, the formal
turning over of the assets to the bondholders is a legal process, not an economic one.
There are legal and administrative costs to bankruptcy, and it has been remarked that
bankruptcies are to lawyers what blood is to sharks.

• In case of bankruptcy the administrator and lawyers most often consume all remaining
value of the firm.
When you have more debt than assets youre brankrupt.
La pregunta es xq sabiendo esto todas las compañías no van fulldebt
- Danger y peligros porq puedes ir a bankrupcy: Hay un bankrpcy cost q hace q la compañía se vaya
al traste

Costs of Financial Distress

• Direct Costs: Legal and administrative costs

• Indirect Costs: Impaired ability to conduct business (e.g., lost sales, suppliers cutting credit,
reputation, etc)

7
 SESSION 19

OPTIMAL CAPITAL STRUCTURE

An important theory of capital structure is called the static theory of capital structure. It says
that firms borrow up to the point where the tax benefit from an extra dollar in debt is exactly
equal to the cost that comes from the increased probability of financial distress.

Dos fotos representan lo mismo.

Cuando llegas a mucho debt el valor d la compañía decrece porq el peligro d q vayas bankrupt va en
aumento.. hay que envontrar the optimal amount of debt
WACC: El coste del wacc es bueno porq empieza a reducirse poco a poco a poco hasta que llega un punto
en el q por endeudarte tanto empieza a aumentar

THE EXTENDED PIE MODE

QUICK QUIZ
• What are the direct and indirect costs of bankruptcy?
• Explain the tradeoff, signaling, agency cost, and pecking order theories.
• What factors affect real-world debt levels?
EXCERCISES:

8
 SESSION 19

EX.1

EX.2

Notice that to calculate the value

of the company with debt we use
MM proposition with taxes we
do not attempt to calculate the
NPV of the savings as the return
on equity will change.

EX.3 A utility company, Water Ltd, expects a EBIT of €1M with an annual growth of 3%.
Corporate tax is 25%. Water Ltd has no debt and its cost of equity is 12%. What is Water Ltd
present value? If Water Ltd was to borrow €500k at an interest rate of 8%, what would be its
value then?
• A utility company, Water Ltd, expects a EBIT of €1M with an annual growth of 3%. Corporate tax
is 25%. Water Ltd has no debt and its cost of equity is 12%. What is Water Ltd present value?
• With no debt WACC equals equity cost: 12%.
• Cash flow of 1M – taxes = 1M*(1-0.25)= 750K
• NPV (of a growing perpetuity) = 750K/(0.12-0.03)=833.333

If Water Ltd was to borrow €500k at an interest rate of 8%, what would be its value then?
- 833.333 is the Vu. To calculate the VL= Vu+D*Tr = 833k+500k*0.25 = 9.583.333
Do you understand why the interest rate of the debt is irrelevant in the MM proposition?