CH14: Capital Structure in a Perfect Market
14.1 Equity versus Debt Financing
The relative proportions of debt, equity, and other securities that a firm has outstanding is the
capital structure
Firms can be financed through mainly two ways:
1. Equity: investors provide some funds and receive part of the future cash flows (stocks,
own equity in firm)
2. Debt: investors provide some funds, and they receive the same amount plus some
interest in the future (loan, mortgages)
The cost of capital = risk free rate + risk premium (the amount investors demand due to
economic uncertainty)
Equity in a firm with no debt is called unlevered equity
Equity in a firm with debt is called levered equity
Debt’s maximum pay-out is fixed, while equity holders earn all the cash flow.
Debt is senior to equity: firms must pay to the debt holders, and the remaining money (if any)
is paid out the equity holders.
Equity holder becomes much riskier when comparing it to debt holders.
More leverage (debt) leads to
i. Higher risk for shareholders (equity holders)
ii. Higher expected returns for shareholders
But the return on assets remains constant, cash flows do not change.
14.2: Modigliani-Miller (MM) l: Leverage, Arbitrage, and Firm Value
Leverage does not affect the total value of the firm under a set of conditions referred to as
perfect capital markets:
i. Investors and firms can trade the same set of securities at competitive market prices
equal to the present value of their future cash flows
ii. There are no taxes, transaction costs, or issuance costs associated with security
trading
iii. A firm’s financing decisions do not change the cash flows generated by its
investment, nor do they reveal new information about them
Homemade leverage: when investors use leverage in their own portfolios to adjust the leverage
choice made by the firm.
MM l: in a perfect capital market, the total value of a firm’s securities is equal to the market
value of the total cash flows generated by its assets and is not affected by its choice of capital
structure
,Thus, we consider them as ‘’negative debt’’, that is, what we call debt is actually net debt (debt
– excess cash)
In a market value balance sheet, all assets and liabilities of the firm are included, and all values
are current market values
Leveraged recap: an operation in which we increase the leverage of the firm without changing
the actual CF of the firm
Value of the firm stays the same, as well as the share price according to the following
14.3: Modigliani-Miller ll: Leverage, Risk, and the Cost of Capital
Some notations:
A: market value/ CF generated by assets
U: value unleveraged firm
E: MV equity
D: MV debt
PCM: perfect capital markets
Recall MM l: A = U = D + E
The law of one price implies that not only the assets, but also the returns should be the same.
MM proposition ll: the cost of capital of levered equity increases with the firm’s market value
debt-equity ratio
With perfect capital markets, a firm’s WACC is independent of its capital structure and is equal
to its equity cost of capital if it is unlevered, which matches the cost of capital of its assets
As the amount of debt increases, the debt becomes riskier because there is a chance the firm
will default. Investors expect higher returns because they are facing a higher risk.
,Higher return must imply a higher market risk. In
particular, the asset’s ’s:
Increasing leverage increases the firm’s ’s.
14.4 Capital Structure Fallacies
Fallacy: an often-plausible argument using false or invalid inference.
i) More leverage increases EPS, then stock prices will increase
The firm decides to ask for a 10 million loan.
What is the EPS?
How many shares can you buy back?
10 million loan / $5 share price = 2 million
New number of shares: 10 – 2 = 8 million
New EPS = Earnings – interest / new number of shares
= 3.5 million – 2% * 10 million (the loan) / 8 million = 0.41
EPS of 0.41 > 0.35. As MM states, the share prices are the same.
A higher EPS means a higher risk.
More leverage might increase EPS, but also might makes the EPS riskier. Leverage does not
affect share price.
ii) Issuing capital increases the number of shares, therefore share prices should
decrease.
New shareholders bring their own piece of pizza. The firm increases value because the new
shares attract new capital. The asset side of the firm grows as much as the new capital
, CH15: Debt and Taxes
We can’t interpret the first permission of MM, so we need to calculate the effect of taxes on
this.
15:1 The Interest Tax Deduction
Firms pay taxes on their profits after interest payments are deducted, interest expenses reduce
the amount of corporate tax firms must pay.
The interest tax shield is the difference in tax payments a firm makes when using leverage.
15.2: Valuing the Interest Tax Shield
Firms pay taxes according to the profits they earn.
Profit = Earnings – operating costs - … - interest payments
Therefore, debt reduces taxes paid by firms.
The interest tax shield (ITS) is the idea that debt form a shield that protect the firms against the
government collecting taxes. It is a corporate tax benefit.
ITS = corporate tax rate * interest payments
When you have
100% debt, you
never need to give
the government a
piece.
The total value of the levered firm exceeds the value of the firm without leverage due to the
present value of the tax savings from debt:
Value L = Value U + PV (interest tax shield)
. We can compute the PV (ITS) under 3 different assumptions:
1. Certain payments (no risk)
First, calculate the ITS, and then calculate the PV of this (ANNUITIY)
2. Constant debt
Suppose a firm borrows (no-risky) debt D and keeps the same level of debt permanently.
- Corporate tax: Tc
