Teaching Note/Dr.

Bulent Aybar

Leverage and Capital Structure: Foundations1

MM Proposition I:

In a perfect capital market, the total value of a firm is equal to the market value of the
free cash flows generated by its assets and is not affected by its choice of capital
structure. We can write this result in an equation:

V L= E + D =V U

This proposition is far more clever than it sounds, and as I indicated in the class it
brought the Nobel Prize in Economics to Modigliani and Miller. Its fundamental insight
is that the operating assets are the primary determinant of firm value, not the way these
assets are financed. MM-I reminds us the value of the operations rather than financial
engineering. Dan Gifforrd puts this more elegantly in a 1998 CFO Magazine Article as
follows2:

“In effect, M&M says don't try to make your shareholders wealthy by adjusting debt
levels, because--at least in the somewhat idealized world in which economists operate,
and sometimes in practice--it won't work. Instead, M&M argues, the company's best
capital structure is one that supports the operations and investments of the business.”

While M&M initially disregarded the impact of the taxes, in a correction article five
years after the publication of the original paper they admitted that it was a mistake.
Modigliani was convinced that tax shield would influnce the firm value and therefore the
way projects are financed. This revision is consistent with views expressed by most
CFO’s and as we indicated in the class the revision recognizes the value of tax shields,
which leads to the following formulation of the levered firm value:

V L= V U + PV(Interest Tax Shiled)

Assuming that the debt undertaken is perpetual, the value of tax shields can be simplu
calculated as

PV(Interest Tax Shiled) =(Debt x Tax Rate) Alternatively, under the same assumption

PV(Interest Tax Shiled) = (Debt x Interest Rate x Tax Rate)/Cost of Debt

1
The discussion on operating, financial and total leverage are not included in this note as it is discussed in length in the
textbook. You should be familiar with these concepts and their operationalization.

2
Dun Gifford Jr. “After the Revolution Forty years ago, the Modigliani-Miller propositions started a new era in
corporate finance. How does M&M hold up today? CFO Magazine July 1, 1998

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 Teaching Note/Dr. Bulent Aybar

D I T
PV(Interest Tax Shield)
rd

One way to conceptualize the value of the tax shield is to think about the financial
characteristics of a debt issue. We know that in perfect capital markets, financing
transactions should have an NPV of zero—the interest and principal repayment should
have exactly a present value of the amount of the bonds. For instance a $2 billion bond
issue in perfect markets should have zero net present value for the firm, because what it
receives and pays out are equal after time value adjustments. However, the interest tax
deductibility makes debt issue a positive-NPV transaction for the firm, simply because
the government effectively subsidizes the payment of interest. Therefore $2bn
perpetual bond issue under 30% marginal tax assumption has an NPV of $600 million
because of interest tax shield.

Alternatively we can see the value of interest tax shield in the form or a reduction in
WACC.

E D E D D
rwacc rE rD (1 T ) rE rD rDTC
E D E D E D E D E D
Pretax WACC Reduction Due
to Interest Tax Shield

Note that the recognition of the Interest Tax Shield or the revision to MM-I under no
circumstances weakens the fundamental insight of original M&M prositions. As it is
succintly put by a CFO

"The availability of the tax deduction is a primary consideration when making a decision
about whether you issue equity or debt," says Hank Wolf, executive vice president of
finance at Norfolk Southern Corp., the railroad and transportation giant based in
Norfolk, Virginia. "The tax benefit, for example, may influence the decision of how you
are going to finance an acquisition or capital investment. But I think there are more
important considerations, such as companywide strategic issues and overall shareholder
value, that come into play."

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 Teaching Note/Dr. Bulent Aybar

MM-II or Second MM Proposition

Second Modigliani Miller Proposition or MM-II indicates that leverage increases the cost
of equity. Under no tax assumption the change in cost of levered equity is captured in
the following equation. Note that MM-I assumes that company can borrow at risk free
rate, and therefore rD=rF:
D
rL rU (r rD )
E U

It simply indicates that increasing debt in the capital structure increases the risk premium
on levered equity, and the increase is proportional to leverage. In the presence of the
taxes the revision leads to the following equation:

D
rL rU (1 T )(rU rD )
E

An alternative way to capture the change in the cost of equity is to focus on the equity
beta. The impact of financial leverage or risk can be captured in firm’s equity beta. An
unlevered firm is exposed to business risk only which is captured by firm’s asset beta.
The impact of levereage is reflected in equity beta.

D
L U (1 (1 T ))
E

According to CAPM, cost of equity of an unlevered firm is

rs rf U EMRP

In contrast, a levered firm’s cost of equity is given as:

D D
rs rf [ U (1 (1 T ))] EMRP rf U EMRP U (1 T ) EMRP
E E

Under the perfect market assumptions of M&M where firms can borrow at risk free rate
of return (i.e. rd=rf ), the mark up for leverage in both approaches to be equal3.

D D
(1 T )(rU rD ) U (1 T ) EMRP
E E

3
In practice, we know that this is not the case, and therefore the theoretical mark up in M&M –II overstates the increase in cost of
equity.

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 Teaching Note/Dr. Bulent Aybar

Example:

Lets assume that ABC generates $104,000 EBIT perpetually. Currently there is no debt in the
capital structure. We have the following data to calculate its value.

Assumptions
Tax Rate 30%
Cost of Debt 6%
Debt 0
Levered Beta
Unlevered Beta 0.8
Risk Free Rate 6%
EMRP 5.50
%
Cost of Equity (no leverage) 0.104

The all equity value of the firm can be derived as follows:

Step-1: Determine the Free Cash Flows to equity

EBIT 104,00
0
Tax 31,200
NOPAT 72,800
Cap Ex 0
NWCI 0
Free Cash Flow 72,800

Step-2; Calculate the cost of equity

rs=rf + U x EMRP = 0.06 +0.8 x 0.055 =0.1040 or 10.40%

Step-3: Calculate the PV of Free Cash Flows to Equity

Since the FCFE is expected to be generated perpetually the value of the unlevered firm is:

FCFE $72,800
Vu $700, 000
rs 0.1040

Now let’s assume that firm issues $380,000 of debt and initially reserves the cash raised from the
equity issue in its cash account. How does the leverage affect the firm value? If the revised
MM-I is correct , we should see an increase in the firm value as much as the PV of its interest tax

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shield. We should also see, firm’s cost of equity to increase because of leverage as suggested by
MM-II propositon. Let’s see if we can verify these two propositions in this example:

Free Cash Flows after the Debt Issue:

Since there is no change in the nature of the operating assets of the firm, free cash flows
generated by the firm’s operating assets will not change. In other words, firm will still generate
72,800 free cash flows after taxes. However, after the debt issue a portion of the free cash flows
will go to creditors. The following summarizes these two observations:

Free Cash Flows to firm generated by the firm’s operating assets does not change:

EBIT 104,000
Tax 31,200
NOPAT 72,800
Cap Ex 0
NWCI 0
Free Cash Flow 72,800

Free Cash Flows to Equity does change:

EBIT 104,000
Interest Payments 22,800
Income Before Taxes 81,200
Tax 24,360
Net Income (Cash to Equity) 56,840

What are the valuation implications of these changes? Let’s first find out the firm value by using
free cash flows to firm.

Step-1: Determine the Free Cash Flows to Firm

As we showed above FCF=72,800

Step-2; Calculate the weighted average cost of capital

A) Calculate cost of equity at the new debt level or D/E level

The new debt of $380,000 increases the debt ratio of the firm to D/V=46.68%. This implies a
D/E ratio of 88%.
D
Levered Beta now is  L U (1 (1 T )) 0.8 [1 (0.88 (1 0.3))] 1.29
E
The cost of equity  rs rf L EMRP 0.06 (1.29 0.055) 13.10%

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 Teaching Note/Dr. Bulent Aybar

B) Calculate after Cost of Debt  rd (1 T ) 0.06 (1 0.3) 4.2%

C) WACC 
D E
rWACC rd (1 T ) rs (0.47) [0.06 (1 0.3)] (0.53) (0.1310) 8.94%
D E D E

Step-3: Find the PV of Free Cash Flows

72,800
PV ( FCF ) 814, 000
0.0894

Note that firm has also $380,000 sitting in its cash account. The total firm value including the
cash should be :

Cash +PV(FCF)=814,000 +380,000 =1,194,000

What is the value claimed by the shareholders? This can be answered in two different ways:

1) Find out the value of FCFE

56,840
PV ( FCFE ) 434, 000
0.1310

As you see, now shareholders have claim only on $434,000 of the total value created by the
operating assets of the firm (the operating assets create a total of 814,000 value). However, note
that cash that is sitting in the balance sheet also belongs to shareholders. This is the case because
creditors claim of 380,000 will be paid out from 814,000 created by the operating assets. The
total value claimed by the shareholders is

Value of Shareholders after Debt Issue=PV(FCFE)+Cash =434,000+380,000=814,000

This means that shareholders capture the value created by the interest tax shield.

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 Teaching Note/Dr. Bulent Aybar

Tradeoff Theory:

Tradeoff Theory posits that the exploitation of interest tax shield comes at increasing and
offsetting costs. The increase in levereage induces financial distress costs, and offsetts the
benefits of interest tax shield. In it original form Tradeoff theory indicates that the value of a
levered firm equals the value of the firm without leverage plus the present value of the tax
savings from debt, less the present value of financial distress costs:

VL VU PV (Interest Tax Shield) PV (Financial Distress Costs)

More modern versions of the tradeoff theory also incoporates the increases in the potential
conflict of interest between creditors and shareholders or agency cost of debt. 4

The probability of financial distress depend on the likelihood that a firm will be unable to meet
its debt commitments and therefore default. This probability increases with the amount of a
firm’s liabilities (relative to its assets). It increases with the volatility of a firm’s cash flows and
asset values. Firms with steady cash flows, such as utility companies, are able to use high levels
of debt and still have a very low probability of default. Firms whose value and cash flows are

4
More modern versions of the tradeoff theory also incoporates the increases in the potential conflict of interest
between creditors and shareholders or agency cost of debt.

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 Teaching Note/Dr. Bulent Aybar

volatile (like semiconductor firms) must have lower levels of debt to avoid a risk of default.
There are two types of financial distress costs:

1) Direct Financial Distress Costs- These costs incurred once the firm bunkrupts; costs such as
legal expenses, firesale of otherwise valuable assets are considered under this category.

2) Indirect Costs of Financial Distress : These costs are incurred once the firm’s stakeholders
percieve the prospect of bunkruptcy. For instance suppliers start to change the terms of credit
and push for immediate collections, clients shy away from company’s products, key employees
start to leave the company etc.

Summary of Tradeoff Theory:

The costs of financial distress reduce the value of the levered firm. The amount of the reduction
increases with the probability of default, which in turn increases with the level of the debt. The
Tradeoff Theory states that firms should increase their leverage until it reaches the maximizing
level. At this point, the tax savings that result from increasing leverage are just offset by the
costs associated with the increased probability of financial distress. ith higher costs of financial
distress, it is optimal for the firm to choose lower leverage.

Agency Costs: Leverage and Principal-Agent Conflict

This separation of ownership and control creates the possibility of management entrenchment.
They may make decisions that:

– benefit themselves at investors’ expense,

– reduce their effort,
– spend excessively on perks such as corporate jets,
– or undertake wasteful projects that increase the size of the firm (and their
paychecks) at the expense of shareholder value, often called “empire building.”

If these decisions have negative NPV for the firm, they are a form of agency cost. Debt can help
provide incentives for managers to run the firm efficiently and effectively. Debt financing has a
disciplinary effect on the management. Debt finance may create a more concentrated ownership
structure and improves monitoring. It also reduces the funds available at management’s
discretion, and forces managers to be more efficient to prevent financial distress.

Agency Costs: Leverage and Shareholder-Creditor Conflict

When there is leverage, a conflict of interest exists if investment decisions have different
consequences for the value of equity and the value of debt. Such a conflict is most likely
to occur when the risk of financial distress is high. In some circumstances, managers
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may take actions that benefit shareholders but harm the firm’s creditors and lower the
total value of the firm. This means that when firms are highly levered up, they face very
high cost of debt, enough to compensate the creditor’s agency costs.

Underinvestment Problem:

Although the direct expenses associated with the bankruptcy process appear small in relation to
market values, the indirect costs can be substantial. For many companies, the most important
indirect cost is the loss in value that results from cutbacks in promising investment when the firm
gets into financial trouble.

• When a company files for bankruptcy, the bankruptcy judge effectively assumes control
of corporate investment policy—and it’s not hard to imagine circumstances in which
judges fail to maximize value. But even in conditions less extreme than bankruptcy,
highly leveraged companies are more likely than their low-debt counterparts to pass up
valuable investment opportunities, especially when faced with the prospect of default.

• In such cases, corporate managers are likely not only to postpone major capital projects,
but to make cutbacks in R&D, maintenance, advertising, travel, or training that end up
reducing future profits.

Overinvestment Problem:

Overinvestment problem is related to the principal-problem mentioned earlier. Managerial

entrenchment, weak monitoring and availability of free cash flows may lead to value destructive
expansion. While the firm growth may be beneficial for the managers themselves, it may be
detrimental to shareholder value.

Pecking Order Theory

The “pecking-order” theory, suggests that actual corporate leverage ratios typically do not reflect
capital structure targets, but rather the widely observed corporate practice of financing new
investments with internal funds when possible and issuing debt rather than equity if external
funds are required. In the Pecking Order model, an equity offering is typically regarded as a very
expensive last resort.

Pecking order theory is based on the premise that managers avoid issuing securities, particularly
equity, when the company is undervalued. Therefore, investors rationally interpret most
management decisions to raise equity as a sign that the firm is overvalued—at least based on
management’s view of the future—and the stock price falls. In other words, a security issue is
perceived as a signal about the equity value of the firm.
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 Teaching Note/Dr. Bulent Aybar

For those companies that are in fact overvalued when the new equity issue is announced,
the drop in price (provided it is not too large) is more of a correction in value than a real
economic cost to shareholders.

• But for those companies that are fairly valued (or even undervalued) at the time of the
announcement, the negative market reaction and resulting undervaluation will cause the
existing shareholders to experience a dilution of value (as distinguished from the dilution
of earnings per share).

Market Timing Hypothesis

It is argued that managers take advantage of the market circumstances to raise funds.
They issue equity when their equity is overvalued, and issue debt, when they think cost
of debt is low.

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