FINANCIAL MANAGEMENT CHAPTER 12

Chapter 12:
Capital Structure
Theory and Taxes

Financial Management, 3e
Megginson, Smart, and Graham

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Capital Structure
The

term capital structure
refers to the mix of debt and
equity securities that a firm uses
to finance its activities.


2

Table 12.1 2009 Long-Term
Debt-to-Assets Ratios


3

Financial Leverage
 The

fundamental principle of financial
leverage:
Substituting

debt for equity increases
expected returns to shareholders—
measured by earnings per share or
ROE—but also increases the risk of
those returns.


4

Financial Leverage


When firms borrow money, we say that they
use financial leverage.

firm with debt on its balance sheet is a levered
firm.
 A firm that finances its operations entirely with equity
is an unlevered firm.
 In Britain, they refer to debt as gearing.
 These terms imply that debt magnifies a firm’s
financial performance in some way.
A



That effect can be either positive or negative,
depending on the returns a firm earns on the
money it borrows.


5

Table 12.2 Current & Proposed Capital
Structures for High-Tech Mfg. Corp.


6

Table 12.3 Expected Cash Flows…
Three Equally Likely Outcomes


7

Figure 12.1 The Effect of Leverage on
the
Sensitivity of EPS to Changes in Cash
Flow


8

What Companies Do Globally
CFO Survey: The Importance of Capital Structure Decisions


9

The Modigliani & Miller
Propositions
 Modigliani

and Miller (M&M)
argument: Capital structure
decisions do not affect firm value.
 Managers

who operate in imperfect markets
can see more clearly how market
imperfections might lead them to choose one
capital structure over another.
 M&M’s argument rests on the principle of no
arbitrage.

10

The M&M Capital Structure
Model
First model to show that capital structure decision
may be irrelevant
Assumes perfect markets, no taxes or transactions
costs
Firm value is determined by:
Key insight

Cash flows
generated

Underlying
business risk

Capital structure merely determines how cash flows and risks are
allocated between bondholders and stockholders.

11

Assumptions of the M&M Capital
Structure Model
markets are perfect – neither
firms nor investors pay taxes or
transactions costs.

 Capital

 Investors

can borrow and lend at the
same rate that corporations can.

 There

are no information
asymmetries.


12

M&M Proposition I
 In

perfect markets, a firm’s total
market value equals the value of its
assets and is independent of the
firm’s capital structure.

 The

value of the assets equals the
present value of the cash flows
generated by the assets.


13

M&M Proposition I


Because the proposition leads to the
conclusion that the firm’s capital structure does
not matter, it is popularly known as the
“irrelevance proposition .”



The firm’s market value equals the present
value of the cash flows it generates regardless
of the capital structure it chooses.


14

M&M Proposition I
Use arbitrage arguments to prove Proposition I.
Proposition I: Market value of a firm is driven by two factors:
cash flow and risk (determines the discount rate).

Firms U and L belong to same risk class and have same
expected EBIT $2,000,000 per year in perpetuity.

Firm U has no debt.
Firm L has both debt and equity.

Required return (r) for firms of
this risk class is 10%.

Under Proposition I, market value of Firms U and L should be identical.

15

Table 12.4 UnleverCo and
LeverCo When Proposition I Holds


Table 12.5 Disequilibrium Values for
UnleverCo and LeverCo If LeverCo’s
Required Return is 12.5%


Additional Example: M&M
Proposition I
Market value of assets
should be $20,000,000

$2,000,000
10%

$2,000,000
10%

Firm U
Earnings before interest (no taxes)
Required return on assets
Market value of assets
Debt

Firm L

$2,000,000

$2,000,000

10%
10%
$20,000,000 $20,000,000
$0

$10,000,000

Interest rate on debt

6%

Interest expense
Shares outstanding
Price per share
Market value of equity

$600,000
1,000,000

500,000

$20

$20

$20,000,000

$10,000,000

Market value of Firm U = 1,000,000 × $20 = $20,000,000
Market value of Firm L = 500,000 × $20 + $10,000,000 = $20,000,000

18

M&M Proposition I
What is the return the shareholders of the two firms expect on their
shares?
Firm U has no
debt.

Required return on equity equals
required return on assets of 10%
Required return on equity = 10%

Firm L pays
$600,000
interest.
EBIT is
$2,000,000.

Shareholders receive a cash
dividend of $1,400,000, or
$2.80/share. Share price = $20.
Required return on equity =
$2.80/$20 = 14%


19

M&M Proposition I
What if the shares of the levered firm are selling at premium?

Firm L
Stock price
Total firm value
Debt value

$25
$20
$22,500,000
$20,000,000
$10,000,000

Shares outstanding

500,000

Dividend per share

$2.80
0.112
0.14

Required return on equity

Assume the stock price of
Firm L is $25.
Total firm value increases
to $22,500,000.
The price of $25 per
share implies a return of
$2.80/$20 = 0.112.

Firm L stockholders can use “homemade leverage” to generate
arbitrage profit.

20

M&M Proposition I
Assume investor
owns 5,000
shares of Firm
L.

•
•
•

The investor owns 1% of Firm L.
He earns $2.80 per share in dividends.
The shares will generate $14,000
each year.

The investor could earn an arbitrage profit from the
following:
Sell 5,000 of Firm L at $25/share

•

Proceeds of $125,000

Borrow an amount equal to 1% of
Firm L debt

•

$100,000 at 6% interest

Buy 1% of Firm U equity

•

10,000 shares at $20 per
share
21


M&M Proposition I
Trades
Proceeds from stock sale

$125,000

Proceeds from borrowing

$100,000

Total proceeds

$225,000

Cost of Firm U shares

-$200,000

Net proceeds

$25,000

•

The net return
on the new
portfolio

•
•

Using homemade
leverage, investor has
built a portfolio of
$200,000 of Firm U's
stock and $100,000 in
personal debt. Investor
has $25,000 remaining.

$2 dividend per share of Firm U, or
$20,000 for 10,000 shares
$6,000 interest expense on borrowed
money
$14,000 cash inflow next year on the
new portfolio

The same return expected on the original 1% stake in Firm L's shares!
The cost of building this portfolio is just $200,000, which is $25,000 less
than the cost of 5,000 Firm L shares.

22

Proposition II and the WACC
 Though

debt is less costly for firms to
issue than equity, issuing debt causes
the required return on the remaining
equity to rise.

 Based

on the core finance principle that
investors expect compensation for risk,
shareholders of levered firms demand
higher returns than do shareholders in
all-equity companies.


23

Proposition II and the WACC
 Proposition

II says that the expected
return on a levered firm’s equity (rl) rises
with the debt-to-equity ratio:

 Proposition

II rearranged is the WACC:


24

Figure 12.2 M&M Proposition II –
The Case of Perfect Capital Markets


25

The M&M Model with
Corporate Taxes
 Firms

can treat interest payments to
lenders as a tax-deductible business
expense.

 Dividend

payments to shareholders
receive no similar tax advantage.

 Intuitively,

this should lead to a tax
advantage for debt, meaning that
managers can increase firm value by
issuing debt.


26

Table 12.6 Income Statements for
UnleverCo and Leverco with Corporate
Income Taxes


27

Determining the Values of
UnleverCo and LeverCo


28

Figure 12.3 Impact of Taxes
on Firm Value


29

Figure 12.3 Impact of Taxes
on Firm Value


30

Example: Corporate Tax Rate
and Corporate Value


31

The M&M Model with
Corporate and Personal
Taxes

 Miller:

Debt’s tax advantage over equity
at the corporate level might be partially or
fully offset by a tax disadvantage at the
individual level.


32

Example: All-Debt Capital
Structure and Personal Taxes


33

What Companies Do Globally:
Tax Factors in Emerging Markets


34

What Companies Do Globally: Net
Gain from Leverage in Emerging
Markets


35

Bond Market Equilibrium with
Corporate and Personal Taxes


Wouldn’t taxable investors also demand a higher
interest rate to compensate them for taxes due?



Yes, but Miller explains that interest rates do not
rise immediately for two reasons:
1.
2.

Some investors, such as endowments and pension
funds, do not have to pay taxes on interest income.
Investors who do not enjoy this tax-exempt status
can buy municipal bonds, which pay interest that is
tax free.


36

Nondebt Tax Shields
(NDTS)
 Companies

with large amounts of
depreciation, investment tax credits, R&D
expenditures, and other nondebt tax
shields should employ less debt financing
than otherwise equivalent companies
with fewer such shields.


37

Figure 12.4 The Effect of Leverage on
Firm Value with and without Taxes


How Taxes Should Affect
Capital Structure
1.

The higher the corporate income tax rate, Tc,
the higher will be the equilibrium leverage level
economy-wide. An increase in Tc should cause
debt ratios to increase for most firms.

2.

The higher the personal tax rate on equityrelated investment income (dividends and
capital gains), Tps, the higher will be the
equilibrium leverage level. An increase in Tps
should cause debt ratios to increase.


39

How Taxes Should Affect
Capital Structure
3.

The higher the personal tax rate on interest
income, Tpd, the lower will be the equilibrium
leverage level. An increase in Tpd should cause
debt ratios to fall.

4.

The more nondebt tax shields a company has,
the lower will be the equilibrium leverage level.


40

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