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MGFC10H3 (10)

Derek Chau (10)

Chapter 16

Department

ManagementCourse Code

MGFC10H3Professor

Derek ChauChapter

16This

**preview**shows half of the first page. to view the full**1 pages of the document.**Chapter 16 Capital Structure: Basic Concepts Notes

16.1 The Capital Structure Question and the Pie Theory

•pie model model of firm’s debt-equity ratio; graphically depicts slices of “pie” that represent value of firm in capital markets

•the value of the firm, V, is V = B + S, where B is the market value of the debt and S is the market value of the equity

•if company management’s goal is to make the firm as valuable as possible, then the firm should pick the debt-equity ratio that

makes the pie—the total value of the company, V—as big as possible

16.3 Financial Leverage and Firm Value: An Example

The Choice Between Debt and Equity

•MM Proposition I a proposition of Modigliani and Miller (MM) stating that a firm cannot change the total value of its

outstanding securities by changing its capital structure proportions; also called an irrelevance result

•MM Proposition I (no taxes): the value of the levered firm is the same as the value of the unlevered firm

16.4 Modigliani and Miller: Proposition II (No Taxes)

Proposition II: Required Return to Equityholders Rises with Leverage

•MM Proposition II a proposition of MM stating that the cost of equity is a linear function of the firm’s debt-equity ratio

•r0 = expected earnings to unlevered firm / unlevered equity

•MM Proposition II (no taxes): rS = r0 + B / S (r0 – rB)

16.5 Taxes

Value of the Levered Firm

•VU = (EBIT × (1 – TC)) / r0 where VU is the present value of an unlevered firm, (EBIT × (1 – TC)) is the firm cash flows after

corporate taxes, TC is corporate tax rate, and r0 is the cost of capital to an all-equity firm

•MM Proposition II (corporate taxes): VL = (EBIT × (1 – TC)) / r0 + TCrBB / rB = VU + TCB

•MM Proposition II (corporate taxes) a proposition of Modigliani and Miller (MM) stating that by raising the debt-equity ratio,

a firm can lower its taxes and thereby increase its total value; capital structure does matter

Expected Return and Leverage under Corporate Taxes

•MM Proposition II (corporate taxes): rS = r0 + (B / S) × (1 – TC) × (r0 – rB)

•S = [(EBIT – rBB) × (1 – TC)] / rS

•the numerator is the expected cash flow to levered equity after interest and taxes

•the denominator is the rate at which the cash flow to equity is discounted

The Weighted Average Cost of Capital, rWACC, and Corporate Taxes

•rWACC = B / VL × rB × (1 – TC) + S / VL × rS

•VL = [EBIT × (1 – TC)] / rWACC

16.6 Summary and Conclusions

1. We began our discussion of the capital structure decision by arguing that the particular capital structure that maximizes the value

of the firm can also be the one that provides the most benefit to the shareholder.

2. In a world of no taxes, the famous Proposition I of Modigliani and Miller proves that the value of the firm is unaffected by the

debt-to-equity ratio. In other words, a firm’s capital structure is a matter of indifference in that world. The authors obtain their

results by showing that either a high or a low corporate ratio of debt to equity can be offset by homemade leverage. The result

hinges on the assumption that individuals can borrow at the same rate as corporations, an assumption believed to be plausible.

3. MM’s Proposition II in a world without taxes states

rS = r0 + B / S (r0 – rB)

This implies that the expected rate of return on equity (also called the cost of equity or the required return on equity) is positively

related to the firm’s leverage. This makes intuitive sense, because the risk of equity rises with leverage.

4. MM imply that the capital structure decision is a matter of indifference, while the decision appears to be a weighty one in the real

world. Still, learning the MM theory has been far from a waste of time. MM’s arguments are a starting point; they show what

does not matter and allow us to relax the assumptions so we can see exactly what does matter in the real world.

5. In a world with corporate taxes but no bankruptcy costs, firm value is an increasing function of leverage. The formula for the

value of the firm is

VL = VU + TCB

Expected return on levered equity can be expressed as

rS = r0 + (B / S) × (1 – TC) × (r0 – rB)

Here, value is positively related to leverage. This result implies that firms should have a capital structure almost entirely

composed of debt.

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