Chapter 16

Capital Structure
Decisions: Part II

Topics in Chapter

MM models:
Without corporate taxes (1958)
With corporate taxes (1963)
Miller model: (1977)
With corporate and personal taxes

Extension to MM with growth and

the
tax shield is risky
Equity as an option
16-2

Modigliani and Miller (MM)

Published theoretical papers that changed

the way people thought about financial
leverage
Nobel prizes in economics
MM 1958
MM 1963
Miller 1977
The papers differed in their assumptions
about taxes.
16-3

Model Assumptions
1. No taxes
2. Business risk measured by EBIT
Firms with same risk = homogeneous
risk class

3. Homogeneous expectations
All investors have same estimates of
firms future EBIT
16-4

Model Assumptions
4. Perfect capital markets
No transactions costs
All can borrow and lend at riskfree rate

5. Debt is riskless
Interest rate on all debt = rf

6. All cash flows are perpetuities

All firms are expect zero growth
All bonds are perpetuities
16-5

MM with Zero Taxes (1958)

No agency or financial distress costs.
VF = EBIT capitalized at WACC
L = Levered rrL = levered return
U = Unlevered

rrU =unlevered return

Proposition I:
EBIT
EBIT
VL VU

WACC
r sU

(16-1)

16-6

MM (1958) Proposition I

Implications:

When there are no taxes, the value of

the firm is independent of its leverage
The WACC is completely independent
of a firms capital structure
Regardless of the amount of debt a
firm uses, its WACC = cost of equity
that it would have if it used no debt
16-7

MM with Zero Taxes (1958)

rrL = levered return
rrU =unlevered return
D = market value of firms debt
S = market value of firms equity
rd = constant cost of debt
Proposition II:
rsL = rsU + (rsU - rd)(D/S)

(16-2)

16-8

MM (1958) Proposition II

When there are no taxes:

(1) The cost of equity to an unlevered firm in
the same risk class, rsU, plus
(2) A risk premium depending on the
difference between an unlevered firms
costs of debt and equity and the amount of
debt used

As debt increases, the cost of equity

also increases, and in a
mathematically precise manner.
16-9

MM (1958) Implications

Using more debt will noe increase

the value of the firm

The benefits of additional debt will be

exactly offset by the increase in the cost
of equity

In a world without taxes, both the

value of the firm and its WACC would
be unaffected by its capital structure.
16-10

MM (1958) Arbitrage Proof

Assume all firms = 0 growth

EBIT remains constant
All earnings paid out as dividends

Dividends Net Income (EBIT - rdD )

S

rsL
rsL
r sL

(16-3)

16-11

MM (1958) Arbitrage Proof

Firms U and L are in same risk class

EBIT (U,L) = $900,000
Firm U has no debt; rsU = 10%

Firm L has $4,000,000 debt at rd = 7.5%

All net income is paid out as dividends

No corporate or personal taxes
Both firms are no growth (g=0)

16-12

Before Any Arbitrage

EBIT rd D
VU SU
$9 ,000 ,000
r sU
EBIT rd D $9 ,000 ,000 0.75 ($4 ,000 ,000 )
SL

r sU
0.10
$600,000

$6 ,000 ,000
0.10
VL DL SL $4 ,000 ,000 $6 ,000 ,000
$10 ,000 ,000
16-13

Before Any Arbitrage

VU = $9,000,000

Dis-equilibrium

VL = $10,000,000

Situation

Suppose you own 10% of Ls stock

Market value = $600,000

If VL >VU, then you can increase your

income without increasing your risk
16-14

Arbitrage Proof
1. Sell your 10% of Ls stock for

$600,000
2. Borrow an amount = 10% of Ls debt
($400,000)
3. Buy 10% of Us stock for $900,000
4. Invest the remaining $100,000 at
7.5%
16-15

Before & After Arbitrage

16-16

Arbitrage Proof
Propositions I and II

Substitute $400,000 of homemade

leverage for Ls leverage
Neither effective debt nor risk has
changed
Profit motive would force price of
Ls stock down and Us up until
market values are equal.
16-17

Propositions I & II
Proposition I:
EBIT
EBIT
VL VU

WACC
rsU

Proposition II:
rsL = rsU + (rsU - rd)(D/S)
16-18

MM Relationships Between Capital

Costs and Leverage (D/V)
Without taxes

Cost of
Capital (%)
26

rs

20
WACC

14

rd

8
0

20

40

60

80

Debt/Value
100 Ratio (%)
16-19

MM Relationships Between
Capital Costs and Leverage (D/V)

The more debt the firm adds to its

capital structure, the riskier the
equity becomes and thus the higher
its cost.
Although rd remains constant, rs
increases with leverage.
The increase in rs is exactly sufficient
to keep the WACC constant.
16-20

MM (1963) with Corporate

Taxes
With corporate taxes added, the MM
propositions become:
Proposition I:
VL = VU + TD
Proposition II:
rsL = rsU + (rsU - rd)(1 - T)(D/S)

(16-4)

(16-6)

16-21

Tax Shield and Value of U

rD DT
TD Tax Shield
rD
EBIT ( 1 T )
VU S
rsU

(16-5)

16-22

Hamadas Equation
b bU [ 1 ( 1 T ) D S )]

(16-7)

Beta increases with leverage

16-23

Notes About the New

Propositions
1. When corporate taxes are added,
VL VU. VL increases as debt is
added to the capital structure, and
the greater the debt usage, the
higher the value of the firm.
2. rsL increases with leverage at a
slower rate when corporate taxes
are considered.
16-24

Frederickson Water
Company

No debt
E(EBIT) = $2,400,000
No growth
All income paid out as dividends
If uses debt, rD=8%

Any debt would be used to repurchase stock

Beta = 0.80 (bU)

Risk-free rate = 8%
rsU = 12%
Market risk premium = 5%
16-25

Value of FWC (No Taxes)

With No Debt & No Taxes
EBIT
VU =
=
rsU

$2.4 m
= $20.0m
0.12

With $10.0m Debt & No Taxes

S=V-D = $20 m - $10 m = $10 m
rsL = rsU + (rsU - rd)(D/S)
= 12% + (12%-8%)($10/$10) = 16%

16-26

FWCs WACC
WACC ( D V )( rD )( 1 T ) ( S V )r sL
($10/$20)(8%)(1.0) ($10/$20)(16%) 12.0%
Value

of the firm and the firms WACC are

independent of the amount of debt

16-27

FWCC with Corporate

Taxes

Tax rate = 40%

Debt = $10 m
EBIT = $4,000,000*

Taxes will reduce net income and

EBIT
EBIT increased to make comparison
easier
16-28

FWCC With Corporate

Taxes
EBIT ( 1 T ) $4 m( 0.60 )
VU S

$20 m
r sU
0.12

VL VU TD $20 m 0.4 ($10 m ) $24 m

S V D $24 m $10 m $14 m
16-29

FWCC with Corporate

Taxes
r sL r sU ( r sU rd )( 1 T )( D )
S
12% ( 12% 8%)( 0.6 )($10 m / $14 m ) 13.71%
WACC ( D / V )( rd )( 1 T ) ( S / V )rsL
($10/$24)(8%)(0.6) ($14/$24)(13.71%) 10.0%
b bU [ 1 ( 1 T ) D S ]
0.80[1 (1 - 0.40) $10m $14m 1.1429

16-30

MM: Capital Costs vs.

Leverage with Corporate
Taxes
Cost of
Capital (%)

rs

26
20
14
8
0

20

40

60

80

WACC
rd(1 - T)
Debt/Value
100
Ratio (%)
16-31

MM: Value vs. Debt with

Corporate Taxes
Value of Firm, V (%)
4

VL

TD

2
1
0

0.5

1.0

1.5

2.0

VU
Debt

2.5 (Millions of $)

Under MM with corporate taxes, the firms value

increases continuously as more and more debt is used.
16-32

Miller Model with Personal

Taxes
Millers Proposition I:
(1 - Tc)(1 - Ts)
(16-12)
VL = V U + 1 D
(1 - Td)
Tc = corporate tax rate
Td = personal tax rate on debt income
Ts = personal tax rate on stock income

16-33

Tc = 40%, Td = 30%, Ts =
12%

VL = V U + 1 -

]
D
(1 - 0.40)(1 - 0.12)

(1 - 0.30)
= VU + (1 - 0.75)D
= VU + 0.25D

Value rises with debt; each $100 increase

in debt raises Ls value by $25.
16-34

Miller vs. MM Model with

Corporate Taxes

If only corporate taxes, then

VL = VU + TcD = VU + 0.40D

Here $100 of debt raises value by

$40.
Personal taxes lowers the gain
from leverage, but the net effect
depends on tax rates.

16-35

Miller Model Implications

( 1 Tc )( 1 Ts )
VL VU 1
D
( 1 Td )

(16-12)

1. The right-hand term = gain from

leverage
2. If taxes ignored, then Miller=Original MM
3. If personal taxes ignored, then Miller =
MM with corporate taxes
16-36

Miller Model Implications

( 1 Tc )( 1 Ts )
VL VU 1
D
( 1 Td )

(16-12)

4. If Ts=Td, right-hand term = Tc

5. If (1-T)(1-T) =(1-T), right-hand

term= 0

No gain to leverage
16-37

Criticisms of MM and Miller

No one believes the models holds precisely

Models assume personal and corporate

leverage are perfect substitutes

Homemade leverage puts stockholders

in grater risk of bankruptcy

Brokerage costs are assumed to be 0

16-38

Criticisms of MM and Miller

No one believes the models holds
precisely
4.
Individuals cannot borrow at the riskfree rate
5.
For the Miller equilibrium to be
reached, the tax benefit from debt
mustbe the same for all firms
6.
MM and Miller assumed no cost to
financial distress
16-39

MM with Nonzero Growth

& A Risky Tax Shield

Under MM (with taxes; no

growth)

VL = V U + T D
This assumes the tax shield is
discounted at the cost of debt.

The debt tax shield will be

larger if the firms grow
16-40

MM with Nonzero Growth

& a Risky Tax Shield
Value of (growing) tax shield =
VTS

rd TD

rTS g

Value of levered firm with

growth: rd
TD
VL VU
rTS g

(16-14)

(16-15)

16-41

MM with Nonzero Growth

& a Risky Tax Shield

If rTS = rsU:

VL VU

rd
TD
rsU g

r sL rsU ( r sU r d ) D S
D
b bU ( bU bd )
S

(16-16)

(16-17)
(16-18)

16-42

Risky Debt

MM and Hamada assume

riskless debt

d = 0

If Bd 0:
rd rRF bd RPM
bd ( rd rRF ) / RPM
16-43

MM Extension with Growth

Peterson Power Illustration

E(FCF) = $1 m
G = 7%
rsU = 12%
T = 40%
VU = $20 m
$10 m debt
rd= 8%
16-44

Peterson Power

rd
0.08 0.40 $10 m
TD $20 m
$26.4 m
0.12 0.07

rsU g
S VL D $26.4 m $10 m $16.4 m

VL VU

rsL rsU ( rsU r d ) D S 12% ( 12% 8%)(

0.3788
) 14.44%
0.6212

WACC 0.3788 ( 1 0.40 )8% ( 1.0 0.3788 )14.44% 10.78%

16-45

FWC vs. PPI

16-46

Cost of Capital for MM and

Extension

16-47

Equity as an Option: Kunkel,

Inc.

Firm value (Debt + Equity) = $20 m

Firm has $10 million face value of 5-year
zero coupon debt coming due soon
If the current value of the firm (D+S) = $9
m:

If firm value > $10 m:

Firm will default on debt; equity holders get 0

Firm pays off the debt; equity holders keep the
firm

Payoff to stockholders = Max(P-$10m,0)

16-48

Notation

V = Value of the option

P = Value of the firm (S+D)
X = strike = value of debt
rRF = risk-free rate
= volatility of the underlying
asset
T = time to maturity in years
16-49

Kunkel Variables

P = $20 million (firm value)

X = $10 million (face value of
debt)
T = 5 years (maturity of debt)
rRF = 6%
= 40%
16-50

The Black-Scholes
Formulas
V P [ N ( d 1 )] X e rRFT [ N ( d 2 ) ]

(16-19)

where :
d1

ln( P / X ) ( rRF

d 2 d1 T

2
/ 2 )T

(16-20)

T
(16-21)

16-51

Formula Functions

ln = natural log

N(x) = the probability that a normally

distributed variable with a mean of
zero and a standard deviation of 1
is less than x

N(d1) and N(d2) denote the standard

normal probability for the values of d1
and d2.
16-52

BSOPM Kunkel Example

P = $20

rRF = 6%

X = $10

T=5

d1

= 40%

ln( P / X ) ( rRF 2 / 2 )T

T
ln( 20 10 ) ( 0.06 0.40 2 2 ) 5
d1
1.5576
0.40 5
d 2 d1 T
d 2 1.5576 0.40 5 0.6632
16-53

BSOPM
Call Price Example
d1 = 1.5576

N(1.5576) = 0.9403

d2 = 0.6632

N(0.6632) = 0.7464

V P N( d 1 ) X e

rT

N( d 2 )

-.065

V 20(0.9403) - 10e
(0.7464)
Vs $13.28 Value of Equity
Vd $20m - $13.28m $6.72 m
16-54

Zero-Coupon Debt Yield

Debt yield for 5-year zero coupon debt

= (Face value / Price)1/5 1
= ($10 million/ $6.72 million) 1
= 8.27%
Yield on debt depends on:

Probability of default
Value of the option

16-55

Managerial Incentives

Managers can change a firm's by

changing the assets the firm invests in.
Changing can:

Change the value of the equity, even if it

doesn't change the expected cash flows
Transfer wealth from bondholders to
stockholders by making the option value of
the stock worth more, which makes what is
left, the debt value, worth less.
16-56

Effect on Option Values

Volatility =

Increased volatility increased upside

potential and downside risk
Increased volatility is NOT good for the
holder of a share of stock
Increased volatility is good for an option
holder

Option holder has no downside risk

Greater potential for higher upside payoff
16-57

Bait and Switch

Managers who know the effect of

volatility, might tell debtholders they
are going to invest in one kind of asset,
and, instead, invest in riskier assets.
Bait and Switch
Bondholders will require:

Higher coupon rates

Strict bond covenants as protection
16-58

Risky Coupon Debt

More complex analysis

With each coupon payment
management has an option on an
option:

If it makes the interest payment then it

purchases the right to later make the
principal payment and keep the firm
This is called a compound option.
16-59

Capital Structure Theory

The Authors View
1.

2.

Debt financing has the benefit

of tax deductibility so firms
should have some debt in their
capital structure
Financial distress and agency
costs place limits on debt
usage
16-60

Capital Structure Theory

The Authors View
Pecking Order

3.

Due to problems from asymmetric

information and flotation costs, lowgrowth firms should follow a pecking
order in raising funds (R/E, debt, new
equity)
High-growth firms whose growth
involves tangible assets should follow
the same pecking order (r/e, debt.
Equity)
16-61

Capital Structure Theory

The Authors View
Pecking Order

3.

4.

High-growth firms whose growth is

primarily in intangible assets should
emphasize stock rather than debt

Firms should maintain reserve

borrowing power

16-62