RSM333 lecture4

# RSM333 lecture4 - Capital Structure Outline I...

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Capital Structure 4 Outline s Theorem 1 s Theorem 2 III. An “all-debt” firm? s The trade-off theory of capital structure s The pecking-order theory

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1 Sabrina Buti, Rotman School of Management, RSM 333 The capital-structure question s The value of a firm is the sum of the value of the firm’s debt and the firm’s equity: V = D + S s First lectures: – Good investment decisions increase firm value s Now: – Can financing decisions increase firm value? – What is the ratio of debt to equity , if any, that maximizes shareholder’s value?
2 Sabrina Buti, Rotman School of Management, RSM 333 The firm is a pie s Can we change the size of the pie by changing the amount of debt and equity? Value of the Firm S D

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3 Sabrina Buti, Rotman School of Management, RSM 333 The Modigliani-Miller theorem (no tax) s Hypotheses – Perfect capital markets: s Firms and investors can borrow/lend at the same rate s Equal access to all relevant information s No transaction costs – No taxes (later we will drop this assumption) s Results – MM I: the value of the firm does not depend on its capital structure – MM II: the required rate of return on equity increases with the debt/equity ratio of the company
Proposed \$10,000 \$5,000 \$5,000 1 10% 500 \$10 4 Sabrina Buti, Rotman School of Management, RSM 333 MM I: Example Current Assets \$10,000 Debt \$0 Equity \$10,000 Debt/Equity ratio 0.00 Interest rate n/a Shares outstanding 1000 Share price \$10 Consider an all-equity firm with 1000 shares, share price of \$10, that wants to borrow \$5,000 at 10% rate of interest to buy back 500 of its shares.

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5 Sabrina Buti, Rotman School of Management, RSM 333 MM I: Example - all equity firm Firm operating income is a perpetuity, and all earnings are paid out as dividends to investors. Expected income is \$1500 and expected return is 15%. All-Equity firm Recession Expected Expansion EBIT \$500 \$1,500 \$2,500 Interest 0 0 0 Net income \$500 \$1,500 \$2,500 EPS \$0.50 \$1.50 \$2.50 ROE 5% 15% 25% Current Shares Outstanding = 1000 shares
6 Sabrina Buti, Rotman School of Management, RSM 333 MM I: Example - Levered firm Expected income is \$1500 and expected return is 15%. Now the firm has 500 shares and a debt of \$5000. Levered firm Recession Expected Expansion EBIT \$500 \$1,500 \$2,500 Interest 500 500 500 Net income \$0 \$1,000 \$2,000 EPS \$0 \$2.00 \$4.00 ROE 0% 20% 40% Shares Outstanding = 500 shares Debt = \$5000 (10%)

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7 Sabrina Buti, Rotman School of Management, RSM 333 Has the pie increased indeed? s Can we say that value has increased? Let’s compare the expected returns on equity! Recession Expected Expansion ROE – all equity firm 5% 15% 25% ROE – Levered firm 0% 20% 40% s Shareholders expect a higher ROE of 20% for the levered firm… has leverage created value?
8 Sabrina Buti, Rotman School of Management, RSM 333 Counter-argument: Homemade leverage Consider the 2 strategies below: s Strategy A: buy 1 share of the levered company

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RSM333 lecture4 - Capital Structure Outline I...

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