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Chapter 16

Chapter 16 Notes


Department
Management
Course Code
MGFC10H3
Professor
Derek Chau
Chapter
16

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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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