Capital Structure I

Professor Allaudeen Hameed

National University of Singapore

Reference: RWJ Chapter 14, 16, 20

Lecture Video: Efficient Market

Hypothesis

1
 Long-Term Financing

• Capital Budgeting involves long-term investments

• Two main sources of long-term financing
• Common Stock
– Represent ownership of firm
– Pay dividends (not obligatory and not tax deductible)
– Control is exercised with voting rights
– Residual claim on corporation
• Long-term debt
• Must be repaid – interest and principal (a liability)
• Interest is tax deductible
• Default on repayment can lead to liquidation of assets and
bankruptcy
• Control is exercised with loan indentures (covenants)

2
 The Capital-Structure Question and
The Pie Theory
• 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
management of the firm is to
S B
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
3
 Which capital structure is better for
stockholders?
• Learning Objectives
• Theory: Modigliani-Miller Model (MM propositions)
• Starting Point: Perfect world (no taxes)
– It doesn’t matter
• Perfect world (with corporate taxes)
– Go for max. debt
• Limits to use of debt
– Optimal capital structure

4
Assumptions of the Modigliani-Miller Model

• Homogeneous Expectations
• Homogeneous Business Risk Classes
• Perpetual Cash Flows
• Perfect Capital Markets:
– Perfect competition
– Firms and investors can borrow/lend at the
same rate
– Equal access to all relevant information
– No transaction costs
– No financial distress or bankruptcy
– No taxes
• ➔ debt doesn’t matter 5
 Effect of Financial Leverage
•Consider an all-equity firm that is considering going into debt.
•Maybe some of the original shareholders want to cash out.
• Ignore tax effects (assume zero tax)
Unlevered Firm Levered Firm
Firm X Firm Y
Market Value of Debt 0 $ 8,000
Market Value of Equity $ 20,000 $ 12,000
Market Value of Firm $ 20,000 $ 20,000

Debt/Equity Ratio 0 2/3

Interest Rate n.a. 8%

Shares Outstanding 400 240

Share Price 50 50

6
 ROE Under Current Capital Structure
(unlevered firm X)

Recession Normal 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%
Probability 1/3 1/3 1/3
Current Shares Outstanding = 400 shares
Equity = 400 shares x $50 = $20,000
What is the expected return on equity? 10%
7
 EPS and ROE Under Proposed Capital
Structure (levered firm Y)

Recession Normal 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 5% 10% 15%
ROE 3% 11% 20%

Proposed Shares Outstanding = 240 shares

Equity Value= 240sharesx$50 = $12,000
𝟏
What is the expected return on equity? 11 %
𝟑 8
 Homemade Leverage: An Example

Recession Normal Expansion

ROE of Unlevered Firm 5% 10% 15%
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% 11% 20%

Investor has $1200 own money. She borrows $800 @ 8%. She
buys 40 shares of unlevered firm. Now, she gets the same ROE as
if she bought into a levered firm. B $800 2
Her personal debt equity ratio is: = =
S $1,200 3 9
Homemade (Un)Leverage: An Example
Recession Normal Expansion
ROE of Levered Firm 3% 11% 20%
EPS of Levered Firm $1.50 $5.67 $9.83
Earnings for 24 shares $36 $136 $236
Plus interest on $800 (8%) $64 $64 $64
Net Profits $100 $200 $300
ROE (Net Profits / $2,000) 5% 10% 15%

Investor B has $2000. He uses $1200 to buy 24

shares and invest the rest ($800) @8%. Now he
gets the ROE of the unlevered firm.
This is the fundamental insight of M&M

10
 The MM Propositions I (No Taxes)
• Proposition I (firm value)
– Firm value is not affected by leverage
VL = VU
• Investors can duplicate the firm’s earnings
under any capital structure.
• Therefore, adopting a particular capital
structure does NOT create additional value to
shareholders.
• Capital Structure is irrelevant to shareholder
wealth max.
• Value of firm (size of pie) depends on capital
budgeting decisions. Capital structure
determines only how the pie is sliced. 11
The MM Proposition I (No Taxes)-

The derivation is straightforward:

Shareholders in a levered firm receive Bondholders receive
EBIT − rB B rB B
Thus, the total cash flow to all stakeholders is
( EBIT − rB B) + rB B
The present value of this stream of cash flows is VL
Clearly
( EBIT − rB B) + rB B = EBIT
The present value of this stream of cash flows is VU

VL = VU 12
 The MM Propositions II (No Taxes)

• Proposition II (cost of capital)

– Leverage (debt) increases both the risk AND
expected 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
13
 The MM Propositions I & II (No Taxes)

• Proposition II (cost of capital)

– Leverage (debt) increases both the risk AND
expected return to stockholders
rs = r0 + (B / SL) (r0 - rB)
Going back to our example of firms X and Y:
1
rs = 10% + (8 / 12) (10% - 8%) = 11 %
3

14
The MM Proposition II (No Taxes)

The derivation is straightforward:

B S
rWACC =  rB +  rS Then set rWACC = r0
B+S B+S
B S B+S
 rB +  rS = r0 multiply both sides by
B+S B+S S
B+S B B+S S B+S
  rB +   rS = r0
S B+S S B+S S
B B+S
 rB + rS = r0
S S

B B B
 rB + rS = r0 + r0 rS = r0 + (r0 − rB )
S S S
15
Levered and Unlevered Betas (no taxes)

(Assume βD=0)

• Leverage amplifies the market risk of a

firm’s assets, βU, raising the market risk
of its equity.
The Cost of Equity, the Cost of Debt, and
the Weighted Average Cost of Capital: MM
Proposition II with No Corporate Taxes
Cost of capital: r (%)

B
rS = r0 +  (r0 − rB )
SL

B S
r0 rW ACC =  rB +  rS
B+S B+S

rB rB

Debt-to-equity Ratio B
S 17
 Summary
• In a perfect world,
– Financial transactions do not add or
substract value, but, represents a
repackaging of risk and return.
• ➔ any value creation must come from market
imperfections

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 Debt and Taxes

• Tax code allows debt interest to be

deducted as business expense but equity
dividends are not deductible.
• Incentive to use debt.

19
 Example: Walmart

Jan ($million)
Walmart Stores (WMT) 2017
Assume
With Debt Zero Debt
EBIT 22,764 22,764
Interest Expense 2,367 0
EBT 20,397 22,764
Tax (30%) 6,119 6,829
Net Income 14,278 15,935

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 Example: Walmart

Total Cash Flow With Debt Without Debt Difference

Interest Paid to Debtholders 2,367 0
Income available to
Equityholders 14,278 15,935
Total Available to all
investors 16,645 - 15,935 = 710

Where did the $710m come from?

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 Example: Walmart

Walmart Stores (WMT) Jan-18 Jan-17 Jan-16 Jan-15

EBIT 22,249 22,764 24,105 27,147
Interest Expense 2,330 2,367 2,548 2,461
EBT 19,919 20,397 21,557 24,686
Tax (30%) 5976 6119 6467 7406
Net Income 13943 14278 15090 17280

Interest Tax shield 699 710 764 738

If Walmart perfectly forecasted the above interest tax

sheild in 2014, what is the value created from the
four years of interest payments?
In reality, is the tax shield certain?
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 Example: Walmart

Walmart Stores (WMT) Jan-18 Jan-17 Jan-16 Jan-15

EBIT 22,249 22,764 24,105 27,147
Interest Expense 2,330 2,367 2,548 2,461
EBT 19,919 20,397 21,557 24,686
Tax (30%) 5976 6119 6467 7406
Net Income 13943 14278 15090 17280

Interest Tax shield 699 710 764 738

2014 2015 2016 2017 2018

Int Tax Shield 738 764 710 699
PV 670.9 631.4 533.43 477.4
Discount Rate 10%

PV $2,313.17 PV of all 4 interest tax shield

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 Total Cash Flow to Investors Under
Each Capital Structure with Corp. Taxes
(All-Equity) Firm X
Recession Normal Expansion
EBIT $1,000 $2,000 $3,000
Interest 0 0 0
EBT $1,000 $2,000 $3,000
Taxes (Tc = 35%) $350 $700 $1,050

Total Cash Flow to S/H $650 $1,300 $1,950

(Levered) Firm Y
Recession Normal Expansion
EBIT $1,000 $2,000 $3,000
Interest ($8000@ 8% ) 640 640 640
EBT $360 $1,360 $2,360
Taxes (Tc = 35%) $126 $476 $826
Total Cash Flow $234+640 $884+$640 $1,534+$640
(to both S/H & B/H): $874 $1,524 $2,174
EBIT(1-Tc)+TCrBB $650+$224 $1,300+$224 $1,950+$224
$874 $1,524 $2,174 24
 The MM Propositions I & II (with
Corporate Taxes)

• Proposition I (firm value)

– 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.

VL = VU + PV of Interest Tax Shield

What if the amount of debt is constant?
VL = VU + TC B
• where TC = corporate tax rate
25
 The MM Propositions I & II (with
Corporate Taxes)
• Proposition II (cost of capital)
– Some of the increase in equity risk and
return is offset by 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

26
 The MM Propositions I & II (with
Corporate Taxes)
• Proposition II (cost of capital)
– Some of the increase in equity risk and
return is offset by interest tax shield
rS = r0 + (B/S)×(1-TC)×(r0 - rB)
Going back to our example of firms X and Y:

rs = 10% + (8 / 12) (10% - 8%) (1-.35)= 10.87%

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The MM Proposition II (Corp. Taxes)

Start with M&M Proposition I with taxes: VL = VU + TC B

Since VL = S + B  S + B = VU + TC B
VU = S + B(1 − TC )
The cash flows from each side of the balance sheet must equal:
SrS + BrB = VU r0 + TC BrB
SrS + BrB = [ S + B(1 − TC )]r0 + TC rB B
Divide both sides by S
B B B
rS + rB = [1 + (1 − TC )]r0 + TC rB
S S S
B
Which quickly reduces to rS = r0 +  (1 − TC )  ( r0 − rB )28
S
The Effect of Financial Leverage on
the Cost of Debt and Equity Capital

Cost of capital: r
(%)

B
rS = r0 +  (1 − TC )  (r0 − rB )
SL

r0
B SL
rWACC =  rB  (1 − TC ) +  rS
B+SL B + SL

rB

Debt-to-equity
ratio (B/S)
29
 Total Cash Flow to Investors Under
Each Capital Structure with Corp. Taxes

All-equity firm Levered firm

S G S G

The levered firm pays less in taxes than does the all-
equity firm.
Thus, the sum of the debt plus the equity of the levered
firm is greater than the equity of the unlevered firm.
30
 Summary: No Taxes
• In a world of no taxes, the value of the firm
is unaffected by capital structure.
• This is M&M Proposition I:
VL = VU
• Prop I holds because shareholders can
achieve any pattern of payouts they desire
with homemade leverage.

• In a world of no taxes, M&M Proposition II

states that leverage increases the risk and
return to stockholders
B
rS = r0 +  (r0 − rB )
SL
31
 Summary: With Corporate Taxes

• In a world of taxes, but no bankruptcy

costs, the value of the firm increases with
leverage.
• This is M&M Proposition I:
VL = VU + TC B
• In a world of taxes, M&M Proposition II
states that leverage increases the risk
and return to stockholders.

B
rS = r0 +  (1 − TC )  (r0 − rB )
SL

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 Personal Taxes
• Investors (shareholders and bondholders) really
care about their cash flow after personal taxes
• Individual investors pay personal marginal tax
on income received – equity income (dividends
and capital gains) ; interest income
• In the US, the personal tax rate on interest
income is higher than personal tax rate on
equity income (capital gains)
• Singapore tax code:
– Income tax (0% to 24%)
– Interest and dividend income: mostly tax
exempt
– Capital gains tax = zero
– Corporate tax rate = 17% since 2010. What
was the tax rate in 1985?
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 Corporate Tax Rates (recent)

• Hong Kong – 16.5%

• Singapore – 17%
• Malaysia– 24%
• China – 25%
• UK – 25%
• India –30%
• Japan – 30%
• US – 26%
• Cayman Islands, Bermuda – 0%
• Asia average – 25%
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 Personal Taxes

• At corporate level: tax advantage of

debt
• At personal investor level: equity
income is taxed at a lower personal
rate (personal tax disadvantage offsets
the corporate tax advantage of debt)
• → suggests we need to look at the net
tax benefit of debt

35
 Personal Taxes: The Miller Model
• The Miller Model shows that the value of a
levered firm can be expressed in terms of
an unlevered firm as:

 (1 − TC )  (1 − TS ) 
VL = VU + 1 − B
 1 − TB 
Where:
TS = personal tax rate on equity income
TB = personal tax rate on bond income
TC = corporate tax rate

36
 Personal Taxes: The Miller Model

The derivation is straightforward:

Shareholders in a levered firm receive

( EBIT − rB B)  (1 − TC )  (1 − TS )
Bondholders receive
rB B  (1 − TB )
Thus, the total cash flow to all stakeholders is
( EBIT − rB B)  (1 − TC )  (1 − TS ) + rB B  (1 − TB )
This can be rewritten as
 (1 − TC )  (1 − TS ) 
EBIT  (1 − TC )  (1 − TS ) + rB B  (1 − TB )  1 − 
 1 − T B37 
Continued…
 Personal Taxes: The Miller Model
The total cash flow to all stakeholders in the levered
firm is:
 (1 − TC )  (1 − TS ) 
EBIT  (1 − TC )  (1 − TS ) + rB B  (1 − TB )  1 − 
 1 − T B 
The first term is the cash A bond is worth B. It promises to
flow of an unlevered firm pay rBB×(1- TB) after taxes. Thus
after all taxes. the value of the second term is:
Its value = VU.  (1 − TC )  (1 − TS ) 
B  1 − 
 1 − TB 
The value of the sum of these
two terms must be VL
 (1 − TC )  (1 − TS ) 
VL = VU + 1 − B
 1 − TB  38
 Personal Taxes: The Miller Model

• Thus the Miller Model shows that the value

of a levered firm can be expressed in terms
of an unlevered firm as:

 (1 − TC )  (1 − TS ) 
VL = VU + 1 − B
 1 − TB 
• In the case where TB = TS, we return to M&M with
only corporate tax:

VL = VU + TC B
39
 Personal Taxes

• If distributions to equity holders are taxed at a lower

effective personal tax rate than interest, the tax
advantage to debt at the corporate level is partially
offset. In fact, the corporate advantage to debt is
eliminated if (1-TC) × (1-TS) = (1-TB)

• In practice, it is very difficult to determine the

effective debt advantage of taxes.
– The tax advantage of debt will vary across firms
and from investor to investor.

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 Capital Structure and Taxes

• Tax effects are relevant but cannot adequately

explain observed capital structures
• What other factors can affect a manager’s
choice of debt-equity mix?
• Other suspects (market imperfections)
– Bankruptcy and financial distress
– Agency costs (manager/ shareholders/
creditors)

42