#2 capital-structure-basics.ppt

#2: Capital Structure: Basic Concepts

Corporate Finance -II (2012)

Prof. Kulbir Singh (IMT-Nagpur)

The Pie

The value of a firm is defined to be the sum of the value of the firm’s debt and the firm’s equity.

V = B + S

• If the goal of the firm’s management is to make the firm as valuable as possible, then the firm should pick the debt-equity ratio that makes the pie as big as possible.

Value of the Firm

S B S B S B S B

Prof. Kulbir Singh (IMT-Nagpur) 2

The usual case

In general, changes in capital structure benefit the stockholders if and only if the value of the firm increases.

Thus, we will be focusing on how to determine optimal capital structure that maximizes firm value.


ABC Inc., an all-equity firm, is contemplating going into debt

Current Assets $20,000 Debt $0 Equity $20,000 Debt/Equity ratio 0.00 Interest rate n/a Shares outstanding 400 Share price $50

Proposed $20,000 $8,000 $12,000 2/3 8% 240 $50 Prof. Kulbir Singh (IMT-Nagpur) 4

EPS and ROE with no debt

Recession Expected Expansion EBIT $1,000 $2,000 $3,000 Interest 0 0 0 Net income $1,000 $2,000 $3,000 EPS $2.50 $5.00 $7.50 ROA 5% 10% 15% ROE 5% 10% 15% Current Shares Outstanding = 400 shares

Prof. Kulbir Singh (IMT-Nagpur)

5

EPS and ROE with debt

Recession Expected Expansion EBIT $1,000 $2,000 $3,000 Interest 640 640 640 Net income $360 $1,360 $2,360 EPS $1.50 $5.67 $9.83 ROA 1.8% 6.8% 11.8% ROE 3.0% 11.3% 19.7% Proposed Shares Outstanding = 240 shares


Financial Leverage and EPS

(2.00)

0.00

2.00

4.00

6.00

8.00

10.00

1,000 2,000 3,000

EPS

Debt

No Debt

Break-even point

EBIT in dollars, no taxes

Advantage to debt

Disadvantage to debt Prof. Kulbir Singh (IMT-Nagpur)

7

MM Proposition I (no taxes)

The value of the levered firm is the same as the value of the unlevered firm.

Capital structure is irrelevant in determining the value of the firm:VL = VU

Assumptions: no corporate taxes; same borrowing rate for firms and individuals.


2 strategies with the same cost and the payoff

The same cost: you have $1,200 in your pocket.

Strategy 1: Borrow $800 and buy 40 shares of unlevered ABC Inc. (40 × $50 per share = $2,000).

Strategy 2: Buy 24 shares of levered ABC Inc. (24 × $50 per share = $1,200).


Homemade leverage: ABC Inc.

Recession Expected Expansion EPS of Unlevered Firm $2.50 $5.00 $7.50 Earnings for 40 shares $100 $200 $300 Less interest on $800 (8%) $64 $64 $64 Net Profits $36 $136 $236 ROE (Net Profits / $1,200) 3.0% 11.3% 19.7% We are buying 40 shares of a $50 stock, using $800 in margin. We get the same ROE as if we bought into a levered firm. Our personal debt-equity ratio is: 3

2200,1$

800$==

SB


Leverage at the firm level

Recession Expected Expansion EPS of Levered Firm $1.50 $5.67 $9.83 Earnings for 24 shares $36 $136 $236 ROE (Net Profits / $1,200) 3.0% 11.3% 19.7% Buying 24 shares of an otherwise identical levered firm along with some of the firm’s debt gets us to the ROE of the unlevered firm. This is the fundamental insight of M&M


MM Proposition I: intuition

Through homemade leverage individuals can either duplicate or undo the effects of corporate leverage.

Is it possible? – Can Individuals can borrow as at lower rate or

same?......margin account with broker! – What if Individuals can borrow at higher rates

than corporations? Is borrowing costs of firms relatively low?.......


MM Proposition II (no taxes)

Proposition II – Leverage increases the risk and return to

stockholders Rs = R0 + (B / SL) (R0 - RB)

RB is the interest rate (cost of debt) Rs is the return on (levered) equity (cost of equity) R0 is the return on unlevered equity (cost of capital) B is the value of debt SL is the value of levered equity


Some algebra

SBW ACC RSB

SRSB

BR ×+

+×+

= 0set Then RRW ACC =

0RRSB

SRSB

BSB =×

++×

+ SSB +by sidesboth multiply

0RS

SBRSB

SS

SBRSB

BS

SBSB

+=×

+×

++×

+×

+

0RS

SBRRSB

SB+

=+×

00 RRSBRR

SB

SB +=+×)( 00 BS RR

SBRR −+=


MM Proposition II (no taxes)

Debt-to-equity Ratio

Cos

t of

capi

tal:

R (%

)

R0

RB

SBW ACC RSB

SRSB

BR ×+

+×+

=

)( 00 BL

S RRSBRR −×+=

RB

SB


Intuition: MM Proposition II

The cost of equity rises with leverage because the risk to equity rises with leverage; the high slope in slide # 9 (with debt).

In other words, although debt, by itself, is cheaper, using more debt does not reduce the cost of capital for the firm.


Total cash flow to investors

The levered firm pays less in taxes than does the all-equity firm.

This is how cutting the pie differently can make the pie “larger.” That is, the government takes a smaller slice of the pie!

S G S G

B

All-equity firm Levered firm


With taxes

Proposition I (with Corporate Taxes) – Firm value increases with leverage

VL = VU + TC B

Numerical Example


With taxes

Proposition II (with Corporate Taxes) – Some of the increase in equity risk and return is

offset by the interest tax shield RS = R0 + (B/S)×(1-TC)×(R0 - RB)

RB is the interest rate (cost of debt) RS is the return on equity (cost of equity) R0 is the return on unlevered equity (cost of capital) B is the value of debt S is the value of levered equity

Numerical


MM Proposition I (with taxes)

BTVV CUL +=∴

BRTBREBIT BCB +−×− )1()(is rsstakeholde all debt to with flowcash totalThe

The present value of this stream of cash flows is VL =+−×− BRTBREBIT BCB )1()(Clearly

The present value of the first term is VU The present value of the second term is TCB

BRTBRTEBIT BCBC +−×−−×= )1()1(BRBTRBRTEBIT BCBBC ++−−×= )1(


With taxes

Debt-to-equity ratio (B/S)

Cost of

capital: R (%)

R0

RB

)()1( 00 BCL

S RRTSBRR −×−×+=

SL

LCB

LW ACC R

SBSTR

SBBR ×

++−××

+= )1(

)( 00 BL

S RRSBRR −×+=


Assignment #1: Mini-case report due

Stephenson Real Estate Recapitalization, (see handout folder)- Section B

Leveraging Mantra of Indian Companies (see handout folder)- Section D

Date of Submission (Next class: 11th Jan, 2012)


Next Class

Capital Structure: Limits to the Use of Debt (11th Jan, 2011)


Economy & Finance

#2 capital-structure-basics.ppt