Basic Concepts

Chapter 6 - Capital Structure 1

A WORLD WITHOUT TAXES

Chapter 6 - Capital Structure 2

1. The value of a firm is the sum of the value of the financial
claims of the firm i.e. firm’s debt and the firm’s equity.
V = B (debt) + S (equity) The market value The market value
of the debt
of the equity

If the goal of the management of

the firm is to make the firm as
valuable as possible, then the
S B
firm should choose the debt-
equity ratio that makes the value
as large as possible.

How should a firm choose its debt-equity

ratio? Value of the Firm (V)

Chapter 6 - Capital Structure 3

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

Chapter 6 - Capital Structure 4

 Suria Company: Market Value – RM1,000 (all equity)
consists of 100 shares of stock which sells for RM10
each. Plans to borrow RM500 and pay the RM500 to
shareholders as cash dividend
What is the value of the firm after proposed
restructure?
 3 possible outcomes:
RM1,250
i. Firm value after restructure > original value
ii. Firm value after restructure = original value RM1,000

iii. Firm value after restructure < original value RM750

iv. Restructuring will not change the firm value
v. ** Management believes restructuring will not change firm value more
than RM250 in either direction.
Chapter 6 - Capital Structure 5
 Before Restructuring After Restructuring
I II III
B RM0 RM500 RM500 RM500
S RM1000 RM750 RM500 RM250
V RM1000 RM1,250 RM1000 RM750

Payoff To Shareholders after Restructuring

I II III
The outcome 1 is most likely.
Although the price of the stock
Dividend RM500 RM500 by RM500
declines RM250, the
shareholders received RM500
Capital Gain/Loss (RM250) dividends, net gain(RM750)
(RM500) of RM250 and
the value of the firm rise by
Gain/Loss to s/h RM250 RM250.
RM0 (RM250)

Conclusion: Capital structure benefit the shareholders if the

value of the firm increases. Chapter 6 - Capital Structure 6
 Consider an all-equity firm proposes to issue debt to
buy back some of its equity
Current Proposed
Assets RM8,000,000 RM8,000,000
Debts 0 RM4,000,000
Equity RM8,000,000 RM4,000,000
Interest 10% 10%
Shares outstanding 400,000 200,000
Share price RM20 RM20

Chapter 6 - Capital Structure 7

 Recession Expected Expansion
EBIT RM400,000 RM1,200,000 RM2,000,000
Interest 0 0 0______
EAI RM400,000 RM1,200,000 RM2,000,000
EPS RM1.00 RM3.00 RM5.00
ROA 5% 15% 25%
ROE 5% 15% 25%
Current Shares Outstanding = 400,000 shares

EPS = EAI / # of shares ROA = EBI / Total Assets

ROE = EAI / Total equity

Chapter 6 - Capital Structure 8

 Recession Expected Expansion
EBIT RM400,000 RM1,200,000 RM2,000,000
Interest 400,000 400,000 400,000
EAI RM0 RM800,000 RM1,600,000
EPS RM0 RM4.00 RM8.00
ROA 0% 15% 25%
ROE 0% 20% 40%
Proposed Shares Outstanding = 200,000 shares

Chapter 6 - Capital Structure 9

1. Under all equity capital structure, EPS is between RM1.00
and RM5.00
2. Under the levered capital structure, EPS is between RM0
and RM8.00
3. EPS under expected condition is higher in a levered
company than in an all equity company (unlevered). It
implies that the expected return rises with leverage (MM
Prop II: No Taxes) because levered firm has fewer shares than
unlevered.
4. EPS and ROE are higher when EBIT is high and lower
when EBIT is low.
5. The effect of financial leverage depends on EBIT
6. Financial leverage increases ROE and EPS when EBIT is
greater than the break-even point
7. The variability of EPS and ROE is increased with leverage
Chapter 6 - Capital Structure 10
 EPS 6.00
Imply that higher
5.00 financial leverage Debt
increases the sensitivity
4.00 of EPS to EBIT No Debt
The levered
firms have 3.00
Advantage to
better return Break-even debt
after BEP & in point
good times. 2.00
The unlevered
firms have
1.00
800,000
better return
before BEP & 0.00
in worse time. Disadvantage to 1.2m
debt EBIT in RM, no taxes
(2.00)
Chapter 6 - Capital Structure 11
i. At the BEP, EPS and ROE are the same under both capital
structure.
ii. If EBIT is below the BEP, then the lower financial leverage
will result in a higher EPS and vice versa.
 Conclusion: Equity holders bear more risk with the
proposed capital structure.
 EPS = EBIT – Interest = EBIT – 400,000
400,000 200,000
EBIT = 800,000, if levered interest is RM400,000 if unlevered interest is 0
 The “optimal” or “target” capital structure is the debt/equity
mix that simultaneously (a) maximizes the value of the firm,
(b) minimizes the WACC, and (c) maximizes the market
value of the common stock.

Chapter 6 - Capital Structure 12

i. Assuming investors can borrow at the same interest as the
firm
ii. 3 investors with 3 different strategies:
Outcome
Buy 15% of unlevered firm Initial Inv. Payoff
SI which generates Earn per 0.15V 0.15 E
u
year. Value of firm = VU
SII Buy 15% stock of levered 0.15SL 0.15(E – I)
firm. Value of firm:
VL = SL + BL
SIII Buy 15% of unlevered firm 0.15Vu -0.15BL 0.15E – 0.15I
using personal borrowings 0.15 (E – I)
of 0.15BL plus own capital
Chapter 6 - Capital Structure 13
a) Compare SII and SIII = same payoff.
b) If the payoff is the same, the initial investment must
also be the same
 0.15SL = 0.15Vu – 0.15BL
 0.15 SL + 0.15BL = 0.15 Vu
 0.15(SL + BL) = 0.15 Vu
 0.15 VL = 0.15Vu
 VL = Vu

Chapter 6 - Capital Structure 14

1. The value of the all equity firm is the same as the
value of the levered firm i.e. Vu=VL
2. If VL >Vu, shareholders can borrow on personal
account and buy shares in all equity company
(homemade leverage). Shareholders get the same
net dividend as in the levered firm. The equilibrium
result would be: Value of levered firm decreases
and value of all equity firm increases until VL =Vu
3. Implication: Firms cannot change the total value of
its outstanding securities by changing proportions
of its capital structure.

Chapter 6 - Capital Structure 15

 From the table 6.2 & 6.3, we can see that the
expected return rises with leverage (ROE 0% to
40%). However, it does not mean that leverage
benefits investors because the risk rises as well which
is shown by the greater fluctuations in the EPS (RM0
to RM8) of the levered firm. This leads to MM
Proposition II, which says that:
◦ “the expected return on equity is positively related
to leverage because the risk of equity increases
with leverage.”

Chapter 6 - Capital Structure 16

1. RWACC for a company is constant either with or without
leverage. Cost of equity + Cost of debt (Table 6.5 – page 200)
2. RWACC = S/B+S (RS) + B/B+S (RB)
3. RWACC = R in a world without corporate tax (= 15% as
O

per Table 6.5)

RO = EBIT
4. RO = cost of capital for an all-equity firm Vu
= Expected earnings to all equity firm
Unlevered equity (Vu)
Vu = EBIT
= RM1,200,000 = 15% RO
RM8,000,000
MM II relates the return on equity, Rs to leverage.
Rs = Ro + B/S (Ro –RB): The required return on equity is a
linear function of the firm’s B/S.

Chapter 6 - Capital Structure 17

 B
r r   (r  r )
S 0 SL 0 B

B S
r0 rW A C C   rB   rS
B  S B  S

rB rB

Debt-to-equity Ratio

Chapter 6 - Capital Structure 18

1. The required return on equity is a linear function of
firm’s debt to equity ratio that is ROE is positively
related to leverage
2. Relation between the cost of equity, rS and the debt
to equity ratio (B/S) is a straight line & linear.
3. As the firm raises the B/S ratio, each dollar of
equity is levered with additional debt. This raises
the risk of equity and therefore the required return,
rS on the equity.
4. rWACC is unaffected by leverage

Chapter 6 - Capital Structure 19

1. Proposition I
◦ Firm value is not affected by leverage
VL = VU

2. Proposition II
◦ Leverage increases the risk and return to
stockholders
rs = r0 + (B / SL) (r0 - rB)

Chapter 6 - Capital Structure 20

A WORLD WITH TAXES

Chapter 6 - Capital Structure 21

 All-equity firm/Unlevered firm Levered firm

Taxes Taxes
S S
B

The levered firm pays less in taxes

than does the all-equity firm. VL > VU
Thus, the sum of the debt plus the Levered firm paying the
equity of the levered firm is greater least in taxes
than the equity of the unlevered firm.

Chapter 6 - Capital Structure 22

 Consider two alternative plans:
Plan I: No debt
Plan II: Debt RM4 million with RB = 10%
Tax: 25%
EBIT: RM1 million
Assuming all cash flows are constant
(perpetual without growth)

Chapter 6 - Capital Structure 23

 Interest = RB x B

Plan I Plan II
EBIT 1,000,000 1,000,000
Interest - (400,000)
EBT 1,000,000 600,000
Tax 250,000 150,000
EAT 750,000 450,000
CF to S/H and B/H 750,000 850,000

100,000

Tax Shield = Tax saved for levered firm = 25% x 10% x 4m

Chapter 6 - Capital Structure
TCxRBxB 24
 Findings
All Equity Firm Levered Firm

Taxable Income EBIT EBIT – RBB = EAI

Total Taxes EBIT (TC) (EBIT – RBB)Tc

EAT to S/holders EBIT(1-Tc) (EBIT-RBB)(1-Tc)

(CF)
CF to both EBIT(1-Tc) EBIT(1-Tc) + TcRBB
S/holders &
B/holders

Chapter 6 - Capital Structure 25

1. Cash flow of levered firm is greater than the unlevered
firm by TcRBB = Tax shield from debt (interest is tax deductible)
2. PV of TcRBB at RB interest rate = TcRBB / RB
3. Value of the Levered Firm: EBIT (1-Tc) + TcRBB

PV of All Equity Firm/unlevered (VU) PV of the tax shield

= EBIT (1 – Tc) = TcRBB = TcB
Ro RB

VL = Vu + TcB

Chapter 6 - Capital Structure 26

 Consider two alternative plans:
Plan I: No debt
RO = 20%
Plan II: Debt RM200 with RB = 10%
Tax rate: 25%
EBIT: RM154
Assumptions:
 All cash flows are constant
 All EAT are paid out as dividend
Chapter 6 - Capital Structure 27
1. RS decreases because the firm pays less tax since interest
is tax-deductible. RS decreases with leverage (with tax)

2. RWACC = B (RB)(1-Tc) + S (RS) RWACC declines with

leverage (with taxes)
V (B+S) V (B+S)
3. Because the tax shield increases with the amount of
debt, the firm can raise its total cash flow and its value
by substituting debt for equity. Therefore, the value of
the levered firm will increase.
4. VL = EBIT (1-Tc)
RWACC Another way to
determine the value
5. S =(EBIT – RBB)(1 – Tc)
RS

Chapter 6 - Capital Structure 28

Cost of capital: r B
(%) r S  r0   ( r0  r B )
SL

B
r S  r0   (1  T C )  ( r 0  r B )
SL

r0

B SL
rW A C C   r B  (1  T C )   rS
B S L B  SL
rB

Debt-to-equity
ratio (B/S)

Chapter 6 - Capital Structure 29

1. Proposition I
◦ Firm value increases with leverage
VL = VU + TC B

2. Proposition II
◦ Some of the increase in equity risk and return is
offset by interest tax shield
rS = r0 + (B/S) × (1-TC) × (r0 - rB)

Chapter 6 - Capital Structure 30

1. In a world of no taxes, the value of the firm is
unaffected by capital structure.
2. This is M&M Proposition I:
VL = VU
3. Prop I holds because shareholders can achieve any
pattern of payouts they desire with homemade leverage.
4. In a world of no taxes, M&M Proposition II states that
leverage increases the risk and return to stockholders
B
r S  r0   ( r0  r B )
SL

Chapter 6 - Capital Structure 31

5. In a world of taxes, but no bankruptcy costs, the
value of the firm increases with leverage.
6. This is M&M Proposition I:
VL = VU + TC B
7. In a world of taxes, M&M Proposition II states that
leverage increases the risk and return to
stockholders.
B
r S  r0   (1  T C )  ( r 0  r B )
SL

Chapter 6 - Capital Structure 32

 Look at Examples 6.5, 6.6,
6.7, 6.8, 6.9, 6.10
 (page 216 – 223)

Chapter 6 - Capital Structure 33

 Text Book: Questions and Problems:
 Q10,11,12,13,14,23,25

 PYQs

Chapter 6 - Capital Structure 34