Chpt015(1).ppt

,Corporate Finance Ross Westerfield Jaffe,Sixth Edition,Chapter Outline,15.1 The Capital-Structure Question and The Pie Theory15.2 Maximizing Firm Value versus Maximizing Stockholder Interests15.3 Financial Leverage and Firm Value:An Example15.4 Modigliani and Miller:Proposition II(No Taxes)15.5 Taxes15.6 Summary and Conclusions,The Capital-Structure Question and The Pie Theory,The value of a firm is defined to be the sum of the value of the firms debt and the firms equity.V=B+S,Value of the Firm,S,B,If the goal of the management of the firm is to make the firm as valuable as possible,the the firm should pick the debt-equity ratio that makes the pie as big as possible.,The Capital-Structure Question,There are really two important questions:Why should the stockholders care about maximizing firm value?Perhaps they should be interested in strategies that maximize shareholder value.What is the ratio of debt-to-equity that maximizes the shareholders value?As it turns out,changes in capital structure benefit the stockholders if and only if the value of the firm increases.,Financial Leverage,EPS,and ROE,CurrentAssets$20,000Debt$0Equity$20,000Debt/Equity ratio0.00Interest raten/aShares outstanding400Share price$50,Proposed$20,000$8,000$12,0002/38%240$50,Consider an all-equity firm that is considering going into debt.(Maybe some of the original shareholders want to cash out.),EPS and ROE Under Current Capital Structure,RecessionExpectedExpansionEBIT$1,000$2,000$3,000Interest000Net income$1,000$2,000$3,000EPS$2.50$5.00$7.50ROA5%10%15%ROE5%10%15%Current Shares Outstanding=400 shares,EPS and ROE Under Proposed Capital Structure,RecessionExpectedExpansionEBIT$1,000$2,000$3,000Interest640640640Net income$360$1,360$2,360EPS$1.50$5.67$9.83ROA5%10%15%ROE3%11%20%Proposed Shares Outstanding=240 shares,EPS and ROE Under Both Capital Structures,LeveredRecessionExpectedExpansionEBIT$1,000$2,000$3,000Interest640640640Net income$360$1,360$2,360EPS$1.50$5.67$9.83ROA5%10%15%ROE3%11%20%Proposed Shares Outstanding=240 shares,All-EquityRecessionExpectedExpansionEBIT$1,000$2,000$3,000Interest000Net income$1,000$2,000$3,000EPS$2.50$5.00$7.50ROA5%10%15%ROE5%10%15%Current Shares Outstanding=400 shares,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,Assumptions of the Modigliani-Miller Model,Homogeneous ExpectationsHomogeneous Business Risk ClassesPerpetual Cash FlowsPerfect Capital Markets:Perfect competitionFirms and investors can borrow/lend at the same rateEqual access to all relevant informationNo transaction costsNo taxes,Homemade Leverage:An Example,RecessionExpectedExpansionEPS of Unlevered Firm$2.50$5.00$7.50Earnings for 40 shares$100$200$300Less interest on$800(8%)$64$64$64Net Profits$36$136$236ROE(Net Profits/$1,200)3%11%20%We are buying 40 shares of a$50 stock on margin.We get the same ROE as if we bought into a levered firm.Our personal debt equity ratio is:,Homemade(Un)Leverage:An Example,RecessionExpectedExpansionEPS of Levered Firm$1.50$5.67$9.83Earnings for 24 shares$36$136$236Plus interest on$800(8%)$64$64$64Net Profits$100$200$300ROE(Net Profits/$2,000)5%10%15%Buying 24 shares of an other-wise identical levered firm along with the some of the firms debt gets us to the ROE of the unlevered firm.This is the fundamental insight of M&M,The MM Propositions I&II(No Taxes),Proposition IFirm value is not affected by leverageVL=VUProposition IILeverage increases the risk and return to stockholdersrs=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 debtSL is the value of levered equity,The MM Proposition I(No Taxes),The derivation is straightforward:,The present value of this stream of cash flows is VL,The present value of this stream of cash flows is VU,The MM Proposition II(No Taxes),The derivation is straightforward:,The Cost of Equity,the Cost of Debt,and the Weighted Average Cost of Capital:MM Proposition II with No Corporate Taxes,Debt-to-equity Ratio,Cost of capital:r(%),r0,rB,rB,The MM Propositions I&II(with Corporate Taxes),Proposition I(with Corporate Taxes)Firm value increases with leverageVL=VU+TC BProposition II(with Corporate Taxes)Some of the increase in equity risk and return is offset by interest tax shieldrS=r0+(B/S)(1-TC)(r0-rB)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 debtS is the value of levered equity,The MM Proposition I(Corp.Taxes),The present value of this stream of cash flows is VL,The present value of the first term is VU The present value of the second term is TCB,The MM Proposition II(Corp.Taxes),Start with M&M Proposition I with taxes:,Since,The cash flows from each side of the balance sheet must equal:,Divide both sides by S,Which quickly reduces to,The Effect of Financial Leverage on the Cost of Debt and Equity Capital,Debt-to-equityratio(B/S),Cost of capital:r(%),r0,rB,Total Cash Flow to Investors Under Each Capital Structure with Corp.Taxes,All-EquityRecessionExpectedExpansionEBIT$1,000$2,000$3,000Interest000EBT$1,000$2,000$3,000Taxes(Tc=35%$350$700$1,050Total Cash Flow to S/H$650$1,300$1,950,LeveredRecessionExpectedExpansionEBIT$1,000$2,000$3,000Interest($800 8%)640640640EBT$360$1,360$2,360Taxes(Tc=35%)$126$476$826Total Cash Flow$234+640$468+$640$1,534+$640(to both S/H&B/H):$874$1,524$2,174EBIT(1-Tc)+TCrBB$650+$224$1,300+$224$1,950+$224$874$1,524$2,174,Total Cash Flow to Investors Under Each Capital Structure with Corp.Taxes,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.,S,G,S,G,B,All-equity firm Levered firm,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=VUProp I holds because shareholders can achieve any pattern of payouts they desire with homemade leverage.In a world of no taxes,M&M Proposition II states that leverage increases the risk and return to stockholders,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 BProp 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.,Prospectus:Bankruptcy Costs,So far,we have seen M&M suggest that financial leverage does not matter,or imply that taxes cause the optimal financial structure to be 100%debt.In the real world,most executives do not like a capital structure of 100%debt because that is a state known as“bankruptcy”.In the next chapter we will introduce the notion of a limit on the use of debt:financial distress.The important use of this chapter is to get comfortable with“M&M algebra”.,