Chapter 16: Capital Structure – Some
Basic Concepts
•
The Capital-Structure Question and The Pie
Theory
•
Maximizing Firm Value versus Maximizing
Stockholder Interests
•
Financial Leverage and Firm Value: An Example
•
Modigliani & Miller: Propositions
I & II (No Taxes)
•
Modigliani & Miller: Propositions I & II with Taxes
•
Summary and Conclusions
1

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
is to make the firm as valuable as
possible, then the firm should
pick the debt-equity ratio that
makes the pie as big as possible.
Value of the Firm
S
B
2

The Capital-Structure Question
There are really two important questions:
1.
Why should the stockholders care about
maximizing
firm
value? Perhaps they should be
interested in strategies that maximize
shareholder
value.
2.
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.
3

Financial Leverage, EPS, and ROE
Current
Assets
$20,000
Debt
$0
Equity
$20,000
Debt/Equity ratio
0.00
Interest rate
n/a
Shares outstanding
400
Share price
$50
Proposed
$20,000
$8,000
$12,000
2/3
8%
240
$50
An all-equity firm is considering going into debt. (Maybe
some of the original shareholders want to cash out.)
4

EPS and ROE Under Current Capital Structure
Recession
Expected
Expansion
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%
Current Shares Outstanding = 400 shares
5

EPS and ROE Under Proposed Capital Structure
Recession
Expected
Expansion
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%
11.3%
19.7%
Proposed Shares Outstanding = 240 shares
6

EPS and ROE Under Both Capital Structures
All-Equity
Recession
Expected
Expansion
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%
Current Shares Outstanding = 400 shares
Levered
Recession
Expected
Expansion
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%
11.3%
19.7%
Proposed Shares Outstanding = 240 shares
7

FINANCIAL LEVERAGE & EPS
INDIFFERENCE EBIT
Under two Capital Structures at what EBIT, EPS will be the same
EBIT/# of shares without debt = (EBIT-Interest)/# of shares with debt
EBIT/400 = (EBIT – 640)/240
Therefore Indifference EBIT = $1600
8

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

FINANCIAL LEVERAGE & EPS
DEGREE OF FINANCIAL LEVERAGE
Is a measure of % change in EPS as a result of each
% change in EBIT
DFL = % Change in EPS/% Change in EBIT
If EBIT change by 1%, EPS will change by 1.47%
10
(9.83
5.67) /5.67
1.47
(3000
2000) / 2000
2000
1.47
2000
640
DFL
OR
EBIT
DFL
EBIT
Interest
−
=
=
−
=
=
−
−

Assumptions of the Modigliani-Miller Model
•
Homogeneous Expectations
•
Homogeneous Business Risk Classes
•
Perpetual Cash Flows
•

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- Fall '16
- SyedAhmed
- Corporate Finance, Debt