1. Capital Structure Decision
MM propositions
Financial management: lecture 10

2. Financial management: lecture 10
Today’s plan
Review what we have learned in the last lecture
The capital structure decision
The capital structure without taxes
MM’s proposition 1
MM’s proposition 2
The capital structure with taxes
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3. What have we learned in the last lecture
In the last lecture, we have discussed the case in the end of chapter 12, what have you learned from this case?
In the last lecture, we have also discussed three forms of market efficiency, what are they and what is your understanding of these three forms of market efficiency?
Financial management: lecture 10

4. Look at the both sides of a balance sheet
Asset
Liabilities and equity
Market value of equity
Market value of the asset E V
Market value of debt D
V=E+D
Financial management: lecture 10

5. Financial management: lecture 10
Capital structure
Capital structure refers to the mix of debt and equity in a firm.
We often use D/E or D/V (V=D+E) to indicate the capital structure of a firm.
Usually, the higher the ratio, the more debt a firm has
The capital structure problem for a firm is to determine what is the maximum amount of debt a firm should have to maximize the firm’s value.
Financial management: lecture 10

6. Does capital structure affect the firm value?
Equity
Debt
Debt
Equity
Debt
Equity
wasted
Govt.
Govt.
Slicing the pie doesn’t
affect the total amount
available to debt
holders and equity holders
Slicing the pie can
affect the size of the
wasted slice
Slicing the pie can
affect the size of the slice
going to government
Financial management: lecture 10

7. Financial management: lecture 10
MM’s proposition 1
Modigliani & Miller
If the investment opportunity is fixed, there are no taxes, and capital markets function well, the market value of a company does not depend on its capital structure.
How can we understand this?
The size of a pizza has nothing to do with how you slice it.
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8. Financial management: lecture 10
MM’s proposition 2
Modigliani & Miller
If the investment opportunity is fixed, there are no taxes, and capital markets function well, the expected rate of return on the common stock of a levered firm increases in proportion to the debt-equity ratio (D/E), expressed in market values.
The WACC is independent of how the firm is financed
Financial management: lecture 10

9. r rE rD WACC without taxes in MM’s view D V WACC
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10. M&M (Debt Policy Doesn’t Matter)
Example - River Cruises - All Equity Financed
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11. M&M (Debt Policy Doesn’t Matter)
Example
cont.
50% debt
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12. M&M (Debt Policy Doesn’t Matter)
Example - River Cruises - All Equity Financed
- Debt replicated by investors
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13. Capital structure and Corporate Taxes
The use of debt has a lot of implications:
Financial risk- The use of debt will increase the risk to share holders and thus Increase the variability of shareholder returns.
Interest tax shield- The savings resulting from deductibility of interest payments.
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14. An example on Tax shield
You own all the equity of Space Babies Diaper Co.. The company has no debt. The company’s annual cash flow is $1,000, before interest and taxes. The corporate tax rate is 40%. You have the option to exchange 1/2 of your equity position for 10% bonds with a face value of $1,000.
Should you do this and why?
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15. Financial management: lecture 10
C.S. & Corporate Taxes
All Equity 1/2 Debt
EBIT 1,000
Interest Pmt
Pretax Income 1,000
40% 400
Net Cash Flow $600
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16. Financial management: lecture 10
C.S. & Corporate Taxes
All Equity 1/2 Debt
EBIT 1,000 1,000
Interest Pmt
Pretax Income 1,
40%
Net Cash Flow $600 $540
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17. Capital Structure and Corporate Taxes
All Equity 1/2 Debt
EBIT 1,000 1,000
Interest Pmt
Pretax Income 1,
40%
Net Cash Flow $600 $540
Total Cash Flow
All Equity = 600
*1/2 Debt = 640
( )
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18. Capital Structure and tax shield
D x rD x Tc rD
PV of Tax Shield =
= D x Tc
Example:
Tax benefit = x (.10) x (.40) = $40
PV of 40 perpetuity = 40 / .10 = $400
PV Tax Shield = D x Tc = 1000 x .4 = $400
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19. MM’s proposition 1 with tax
firm value = value of all equity firm + PV(tax shield)
Example,
all equality firm value =600/0.1=6,000
PV( tax shield)=400
firm value=6,400
Financial management: lecture 10

20. Financial management: lecture 10
MM’s proposition 2
The weighted average cost of capital is decreasing with the ratio of D/E, that is
Can you understand this intuitively?
Financial management: lecture 10

21. Financial management: lecture 10
WACC Graph
Financial management: lecture 10

22. Financial management: lecture 10
Financial Distress
Costs of Financial Distress - Costs arising from bankruptcy or distorted business decisions before bankruptcy.
Market Value = Value if all Equity Financed
+ PV Tax Shield
- PV Costs of Financial Distress
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23. Financial management: lecture 10
Financial distress
Costs of Financial Distress - Costs arising from bankruptcy or distorted business decisions before bankruptcy.
Market Value = Value if all Equity Financed
+ PV Tax Shield
- PV Costs of Financial Distress
Financial management: lecture 10

24. Optimal Capital structure
Trade-off Theory - Theory that capital structure is based on a trade-off between tax savings and distress costs of debt.
Pecking Order Theory - Theory stating that firms prefer to issue debt rather than equity if internal finance is insufficient.
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25. Financial management: lecture 10
Financial Distress
Maximum value of firm
Costs of
financial distress
Market Value of The Firm
PV of interest
tax shields
Value of levered firm
Value of
unlevered
firm
Optimal amount
of debt
Debt
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