Chapter 26

Analysis of Capital Structure Theory

1
Topics in Chapter

 MM models, with and without corporate

taxes
 Miller model, with corporate and
personal taxes
 Extension to MM when there is growth
and the tax shield is risky
 Equity as an option

2
 Determinants of Intrinsic Value:
The Capital Structure Choice

Net operating Required investments

−
profit after taxes in operating capital

Free cash flow

=
(FCF)

FCF1 FCF2 FCF∞

Value = + + ··· +
(1 + WACC)1 (1 + WACC)2 (1 + WACC)∞

Weighted average Firm’s

cost of capital debt/equity
(WACC) mix

Market interest rates Cost of debt

Cost of equity
Market risk aversion Firm’s business risk
3
Who are Modigliani and Miller
(MM)?
 They published theoretical papers that
changed the way people thought about
financial leverage.
 They won Nobel prizes in economics because
of their work.
 MM’s papers were published in 1958 and
1963. Miller had a separate paper in 1977.
The papers differed in their assumptions
about taxes.
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What assumptions underlie
the MM and Miller Models?
 Firms can be grouped into
homogeneous classes based on
business risk.
 Investors have identical expectations
about firms’ future earnings.
 There are no transactions costs.

(More...)
5
 All debt is riskless, and both individuals
and corporations can borrow unlimited
amounts of money at the risk-free rate.
 All cash flows are perpetuities. This
implies perpetual debt is issued, firms
have zero growth, and expected EBIT is
constant over time.
(More...)
6
 MM’s first paper (1958) assumed zero
taxes. Later papers added taxes.
 No agency or financial distress costs.
 These assumptions were necessary for
MM to prove their propositions on the
basis of investor arbitrage.

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MM with Zero Taxes (1958)

Proposition I:
VL = VU.

Proposition II:
rsL = rsU + (rsU - rd)(D/S).

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Given the following data, find V, S,
rs, and WACC for Firms U and L.

 Firms U and L are in same risk class.

 EBITU = EBITL = $500,000.
 Firm U has no debt; rsU = 14%.
 Firm L has $1,000,000 debt at rd = 8%.
 The basic MM assumptions hold.
 There are no corporate or personal
taxes.
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 1. Find VU and VL.

EBIT $500,000
VU = = = $3,571,429.
rsU 0.14

VL = VU = $3,571,429.

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2. Find the market value of
Firm L’s debt and equity.

VL = D + S = $3,571,429
$3,571,429 = $1,000,000 + S
S = $2,571,429.

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 3. Find rsL.

rsL = rsU + (rsU - rd)(D/S)

= 14.0% + (14.0% - 8.0%) ( )

$1,000,000
$2,571,429
= 14.0% + 2.33% = 16.33%.

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 4. Proposition I implies WACC = rsU.
Verify for L using WACC formula.

WACC = wdrd + wcers = (D/V)rd + (S/V)rs

$1,000,000
( )
= $3,571,429 (8.0%)
$2,571,429
+($3,571,429)(16.33%)

= 2.24% + 11.76% = 14.00%.

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 MM Relationships Between Capital Costs
and Leverage (D/V)

Cost of Without taxes

Capital (%)
26 rs
20
14 WACC

8 rd
Debt/Value
0 20 40 60 80 100 Ratio (%)
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 The more debt the firm adds to its
capital structure, the riskier the equity
becomes and thus the higher its cost.
 Although rd remains constant, rs
increases with leverage. The increase
in rs is exactly sufficient to keep the
WACC constant.

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 Graph value versus leverage.
Value of Firm, V (%)
4
VU VL
3
Firm value ($3.6 million)
2
1
0 0.5 1.0 1.5 2.0 2.5
Debt (millions of $)
With zero taxes, MM argue that value
is unaffected by leverage. 16
 V, S, rs, and WACC for Firms U and L
(40% Corporate Tax Rate)

With corporate taxes added, the MM

propositions become:
Proposition I:
VL = VU + TD.
Proposition II:
rsL = rsU + (rsU - rd)(1 - T)(D/S).
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Notes About the New
Propositions
 1. When corporate taxes are added,
VL ≠ VU. VL increases as debt is added
to the capital structure, and the greater
the debt usage, the higher the value of
the firm.
 2. rsL increases with leverage at a
slower rate when corporate taxes are
considered.
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 1. Find VU and VL.

VU =
EBIT(1 - T) =
$500,000(0.6) = $2,142,857.
rsU 0.14

Note: Represents a 40% decline from the no

taxes situation.
VL = VU + TD = $2,142,857 + 0.4($1,000,000)
= $2,142,857 + $400,000
= $2,542,857.
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2. Find market value of Firm
L’s debt and equity.

VL = D + S = $2,542,857
$2,542,857 = $1,000,000 + S
S = $1,542,857.

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3. Find rsL.

rsL = rsU + (rsU - rd)(1 - T)(D/S)

( $1,000,000
= 14.0% + (14.0% - 8.0%)(0.6) $1,542,857)
= 14.0% + 2.33% = 16.33%.

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 4. Find Firm L’s WACC.

WACCL = (D/V)rd(1 - T) + (S/V)rs

$1,000,000
( )
= $2,542,857 (8.0%)(0.6)
$1,542,857
( )
+ $2,542,857 (16.33%)

= 1.89% + 9.91% = 11.80%.

When corporate taxes are considered, the WACC is
lower for L than for U.
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 MM: Capital Costs vs. Leverage
with Corporate Taxes

Cost of
Capital (%)
rs
26
20
14
WACC
8 rd(1 - T)
Debt/Value
0 20 40 60 80 100 Ratio (%)
23
 MM: Value vs. Debt with
Corporate Taxes

Value of Firm, V (%)

4
VL
3 TD
2 VU

1 Debt
0 0.5 1.0 1.5 2.0 2.5 (Millions of $)
Under MM with corporate taxes, the firm’s value
increases continuously as more and more debt is used.
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 Miller Model with Personal Taxes (Td =
30% and Ts = 12%)

Miller’s Proposition I:
(1 - Tc)(1 - Ts)
[
VL = VU + 1 - (1 - Td) ]D.
Tc = corporate tax rate.
Td = personal tax rate on debt income.
Ts = personal tax rate on stock income.
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 Tc = 40%, Td = 30%, and
Ts = 12%.

[
VL = VU + 1 -
(1 - 0.40)(1 - 0.12)
(1 - 0.30) ]
D

= VU + (1 - 0.75)D
= VU + 0.25D.

Value rises with debt; each $100 increase

in debt raises L’s value by $25.
26
Miller vs. MM Model with
Corporate taxes
 If only corporate taxes, then
VL = VU + TcD = VU + 0.40D.
 Here $100 of debt raises value by $40.
Thus, personal taxes lowers the gain
from leverage, but the net effect
depends on tax rates.

(More...)
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 If Ts declines, while Tc and Td remain
constant, the slope coefficient (which
shows the benefit of debt) is decreased.
 A company with a low payout ratio gets
lower benefits under the Miller model
than a company with a high payout,
because a low payout decreases Ts.

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Why do personal taxes lower value of
debt?

 Corporate tax laws favor debt over

equity financing because interest
expense is tax deductible while
dividends are not.

(More...)
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 However, personal tax laws favor equity over
debt because stocks provide both tax deferral
and a lower capital gains tax rate.
 This lowers the relative cost of equity vis-a-
vis MM’s no-personal-tax world and decreases
the spread between debt and equity costs.
 Thus, some of the advantage of debt
financing is lost, so debt financing is less
valuable to firms.

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What does capital structure theory
prescribe for corporate managers?
 MM, No Taxes: Capital structure is irrelevant-
-no impact on value or WACC.
 MM, Corporate Taxes: Value increases, so
firms should use (almost) 100% debt
financing.
 Miller, Personal Taxes: Value increases, but
less than under MM, so again firms should
use (almost) 100% debt financing.

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Do firms follow the recommendations
of capital structure theory?

 Firms don’t follow MM/Miller to 100%

debt. Debt ratios average about 40%.
 However, debt ratios did increase after
MM. Many think debt ratios were too
low, and MM led to changes in financial
policies.

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How is analysis different if firms
U and L are growing?
 Under MM (with taxes and no growth)
 VL = VU + TD
 This assumes the tax shield is discounted at
the cost of debt.
 Assume the growth rate is 7%
 The debt tax shield will be larger if the
firms grow:

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7% growth, TS discount rate
of rTS

Value of (growing) tax shield =

VTS = rdTD/(rTS –g)
So value of levered firm =
VL = VU + rdTD/(rTS – g)

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What should rTS be?

 The smaller is rTS, the larger the value of

the tax shield. If rTS < rsU, then with
rapid growth the tax shield becomes
unrealistically large—rTS must be equal to
rU to give reasonable results when there
is growth. So we assume rTS = rsU.

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 Levered cost of equity

 In this case, the levered cost of equity is

rsL = rsU + (rsU – rd)(D/S)
 This looks just like MM without taxes
even though we allow taxes and allow for
growth. The reason is if rTS = rsU, then
larger values of the tax shield don't
change the risk of the equity.
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Levered beta

 If there is growth and rTS = rsU then the

equation that is equivalent to the
Hamada equation is
 bL = bU + (bU - bD)(D/S)
 Notice: This looks like Hamada without
taxes. Again, this is because in this
case the tax shield doesn't change the
risk of the equity. 37
Relevant information for
valuation
 EBIT = $500,000
 T = 40%
 rU = 14% = rTS
 rd = 8%
 Required reinvestment in net operating
assets = 10% of EBIT = $50,000.
 Debt = $1,000,000
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Calculating VU

NOPAT = EBIT(1-T)
= $500,000 (.60) = $300,000
Investment in net op. assets
= EBIT (0.10) = $50,000
FCF = NOPAT – Inv. in net op. assets
= $300,000 - $50,000
= $250,000 (this is expected FCF next year)

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Value of unlevered firm, VU
 Value of unlevered firm =
VU = FCF/(rsU – g)
= $250,000/(0.14 – 0.07)
= $3,571,429

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Value of tax shield, VTS and VL

VTS = rdTD/(rsU – g)
= 0.08(0.40)$1,000,000/(0.14-0.07)
= $457,143

VL = VU + VTS
= $3,571,429 + $457,143
= $4,028,571 41
Cost of equity and WACC
 Just like with MM with taxes, the cost of
equity increases with D/V, and the
WACC declines.
 But since rsL doesn't have the (1-T)
factor in it, for a given D/V, rsL is
greater than MM would predict, and
WACC is greater than MM would
predict.
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Cost of Capital for MM and
Extension
40%
35%
MM cost of equity
30%
25% MM WACC
20%
Extension cost of
15% equity
10% Extension WACC
5%
0%
0% 10% 20% 30% 40% 50% 60% 70% 80%
D/V

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What if L's debt is risky?
 If L's debt is risky then, by definition,
management might default on it. The
decision to make a payment on the
debt or to default looks very much like
the decision whether to exercise a call
option. So the equity looks like an
option.

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Equity as an option
 Suppose the firm has $2 million face value of
1-year zero coupon debt, and the current
value of the firm (debt plus equity) is $4
million.

 If the firm pays off the debt when it matures,

the equity holders get to keep the firm. If
not, they get nothing because the
debtholders foreclose.
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Equity as an option
 The equity holder's position looks like a
call option with
 P = underlying value of firm = $4
million
 X = exercise price = $2 million
 t = time to maturity = 1 year
 Suppose rRF = 6%
  = volatility of debt + equity = 0.60
46
Use Black-Scholes to price
this option

V = P[N(d1)] - Xe –rRFt [N(d2)].

ln(P/X) + [rRF + (σ2/2)]t .
d1 =
√σ t

d2 = d1 √- σ t .
47
Black-Scholes Solution

V = $4[N(d1)] - $2e -(0.06)(1.0) [N(d2)].

ln($4/$2) + [(0.06 + 0.36/2)](1.0)

d1 =
(0.60)(1.0)
= 1.5552.
d2 = d1 – (0.60)(1.0) = d1 – 0.60
= 1.5552 – 0.6000 = 0.9552. 48
N(d1) = N(1.5552) = 0.9401
N(d2) = N(0.9552) = 0.8383
Note: Values obtained from Excel using
NORMSDIST function.

V = $4(0.9401) - $2e-0.06(0.8303)
= $3.7604 - $2(0.9418)(0.8303)
= $2.196 Million = Value of Equity
49
Value of Debt
 The value of debt must be what is left
over:

Value of debt = Total Value – Equity

= $4 million – 2.196 million
= $1.804 million

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This value of debt gives us a
yield
 Debt yield for 1-year zero coupon debt
= (face value / price) – 1
= ($2 million/ 1.804 million) – 1
= 10.9%

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How does  affect an option's
value?
 Higher volatility  means higher option
value.

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Managerial Incentives
 When an investor buys a stock option,
the riskiness of the stock () is already
determined. But a manager can change
a firm's  by changing the assets the
firm invests in. That means changing 
can change the value of the equity,
even if it doesn't change the expected
cash flows:
53
Managerial Incentives
 So changing  can transfer wealth from
bondholders to stockholders by making
the option value of the stock worth
more, which makes what is left, the
debt value, worth less.

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Value of Debt and Equity for
Different Volatilities
$3.00

$2.50
Value (Millions)

$2.00
Equity
$1.50
Debt
$1.00

$0.50

$0.00
2 3 4 5 6 7 8 9
0. 0. 0. 0. 0. 0. 0. 0.
Volatility (Sigma)

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Bait and Switch
 Managers who know this might tell
debtholders they are going to invest in
one kind of asset, and, instead, invest
in riskier assets. This is called bait and
switch and bondholders will require
higher interest rates for firms that do
this, or refuse to do business with
them.
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If the debt is risky coupon
debt
 If the risky debt has coupons, then with
each coupon payment management has
an option on an option—if it makes the
interest payment then it purchases the
right to later make the principal
payment and keep the firm. This is
called a compound option.

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