FNCE 3P93 Study Guide - Final Guide: Capital Structure, Tax Shield, Weighted Arithmetic Mean

Franco Modigliani and Merton Miller (M & M) are two very famous financial economists that both won the Nobel Prize in Economics for their work in the finance area, particularly in capital structure theories (see the Description of this in the box on page 504 of your text). In their famous 1958 article (see footnote on page 490), they argued that with perfect capital markets, the total value of a firm should not depend on its capital structure. In other words, the total value of a firm would be the same with all equity, or financing with 100% debt. This is the basic MM Proposition I stated on p.493. But, as you should see, the "perfect capital markets" assumes 3 key assumptions, including no taxes or transactions costs dealing with equity or debt. Additionally, a key assumption is that individuals and firms can trade the same set of securities at competitive market prices equal to the present value of their future cash flows. These assumptions are necessary for the M&M theory on capital structure. For the Proposition M&M II beginning on page 498, still in a perfect capital market which includes no taxes, M&M state that the cost of capital of EQUITY increases with the firm's market value debt-equity ratio. But, when you examine this Proposition more closely, for a new investment the cost of capital will equal the weighted average of the firm's equity and debt costs. What does this mean in practical terms? It means that M&M "loosens" a part of the Proposition I, and admit that the cost of equity does increase as the debt-equity ratio increases. But, if you examine this closely, it means that the OVERALL cost of capital, captured in the WACC stays constant. And, the pre-tax WACC is the same as the after-tax WACC, since there is no tax! If the WACC stays constant while the equity cost increases, the figure also shows that the debt costs are also going up; similarly, if the equity costs are going down, then the debt costs are going down also as the debt-to-value decreases. This is shown on page 500 in Figure 14.1. And, of course, the weights of debt and equity (0/100, 25/75, 50/50, 75/25, 100/0) count. But, in the real-world, the M&M Propositions do not hold....corporations and individuals do have taxes, and do have transactions costs for debt and equity...buying bonds and stocks, for example. So, as we have learned, the Beta coefficient for equity does increase as the amount of debt level increases (due to increasing risks of default of interest payments or repayment of the bonds at maturity)...and the costs of debt increase, but as we weight those, the WACC actually varies, based on the real-world that includes taxes....we normally see the WACC being a U-shaped curved that varies as a function of the debt to equity ratio.

Questions:

1. Discuss the MM Proposition I and MM Proposition II (definition, assumptions, results and implications)? Remember, at the MBA level, more is better. But, to the point, and no "hot air."

2. Assume you are doing a financial analysis for Kroger Inc. Here is one of the income statements that you analyze (all figures in $ Millions):

Which year does Kroger Incorporation have the highest tax shield and why? Be very specific.

Franco Modigliani and Merton Miller (M & M) are two very famous financial economists that both won the Nobel Prize in Economics for their work in the finance area, particularly in capital structure theories (see the Description of this in the box on page 504 of your text). In their famous 1958 article (see footnote on page 490), they argued that with perfect capital markets, the total value of a firm should not depend on its capital structure. In other words, the total value of a frim would be the same with all equity, or financing with 100% debt. This is the basic MM Proposition I stated on p.493. But, as you should see, the "perfect capital markets" assumes 3 key assumptions, including no taxes or transactions costs dealing with equity or debt. Additionally, a key assumption is that individuals and firms can trade the same set of securities at competitive market prices equal to the present value of their future cash flows.

These assumptions are necessary for the M&M theory on capital structure.

For the Proposition M&M II beginning on page 498, still in a perfect capital market which includes no taxes, M&M state that the cost of capital of EQUITY increases with the firm's market value debt-equity ratio. But, when you examine this Proposition more closely, for a new investment the cost of capital will equal the weighted average of the firm's equity and debt costs. What does this mean in practical terms? It means that M&M "loosens" a part of the Proposition I, and admit that the cost of equity does increase as the debt-equity ratio increases. But, if you examine this closely, it means that the OVERALL cost of capital, captured in the WACC stays constant. And, the pre-tax WACC is the same as the after-tax WACC, since there is no tax! If the WACC stays constant while the equity cost increases, this means that the debt costs are going down,relatively; on the contrary, if the equity costs are going down, then the debt costs are going up. This is shown on page 500 in Figure 14.1. And, of course, the weights count.

But, in the real-world, the M&M Propositions do not hold....corporations and individuals do have taxes, and do have transactions costs for debt and equity...buying bonds and stocks, for example.

So, as we have learned, the Beta coefficient for equity does increase as the amount of debt level increases (due to increasing risks of default of interest payments or repayment of the bonds at maturity)...and the costs of debt increase, but as we weight those, the WACC actually varies, based on the real-world that includes taxes....we normally see the WACC being a U-shaped curved that varies as a function of the debt to equity ratio.

That is the background for this Written Assignment. Dr. Steadman

) Discuss the MM Proposition I and MM Proposition II (definition, assumptions, results and implications)? Remember, at the MBA level, more is better. But, to the point, and no "hot air."

(ALL WORK MUST BE DONE ON EXCEL)

Build a financial model on the following template. Assume that the WACC is 20%. Also assume the debt and equity remain the same. The FCF long-term growth rate is the same as the sales growth rate. ( Copy the table into Excel.)

a. Value the company’s equity. (SHOW YOUR WORK ON EXCEL)

b. The model in Part A includes cost of goods sold but not selling, general, and administrative (SG & A) expenses. Suppose that the firm has $200 of these expenses each year, irrespective of the level of sales. Change the model to accommodate this new assumption. Show the resulting income statements, balance sheets, the free cash flows (FCF), and the valuation. (SHOW YOUR WORK ON EXCEL)

c. Build a data table in which you show the sensitivity of the equity value to the level of SG & A. Let SG & A vary from $0 per year to $600 per year. (SHOW YOUR WORK ON EXCEL)

d. Back to Part A. Suppose that the fixed assets at cost follow the following step function:

Incorporate this function into the model and solve for the market value of equity. (SHOW YOUR WORK ON EXCEL)

e. Back to Part A again. Make two changes in the model: 1). Let debt be the plug and keep cash constant at its year-0 level. 2). Suppose that the firm has 1,000 shares and that it decides to pay, in year 1, a dividend per share of $0.15. In addition, suppose that it wants this dividend per share to growth in subsequent years by 12% per year. Incorporate these changes into the pro forma model and solve this model to get the market value of equity per share. (SHOW YOUR WORK ON EXCEL)