Chapter 14: Capital Structure in a Perfect Market

Equity vs Debt Financing

The relative proportions of debt, equity, and other securities that a firm has outstanding
constitute its capital structure.

Financing a firm with Equity

The collection of securities a firm issues to raise capital from investors is called the firm’s
capital structure. Equity and debt are the securities most commonly used by firms. When
equity is used without debt, the firm is said to be unlevered. Otherwise, the amount of
debt determines the firm’s leverage.

cost of capital unlevered firm= Risk-free rate + risk premium

The owner of a firm should choose the capital structure that maximizes the total value of the
securities issued.

Modigliani-Miller I: Leverage, Arbitrage, and Firm Value

Capital markets are said to be perfect if they satisfy three conditions:

●​ Investors and firms can trade the same set of securities at competitive market
prices equal to the present value of their future cash flows.

●​ There are no taxes, transaction costs, or issuance costs associated with

security trading.

●​ A firm’s financing decisions do not change the cash flows generated by its
investments, nor do they reveal new information about them.

MM Proposition I: In a perfect capital market, the total value of a firm’s securities is equal to
the market value of the total cash flows generated by its assets and is not affected by its
choice of capital structure.

●​ MM showed that the firm’s value is not affected by its choice of capital
structure. But suppose investors would prefer an alternative capital structure
to the one the firm has chosen. MM demonstrated that in this case, investors
 can borrow or lend on their own and achieve the same result. - With
perfect capital markets, homemade leverage is a perfect substitute for firm
leverage.
●​ If otherwise identical firms with different capital structures have different
values, the Law of One Price would be violated and an arbitrage opportunity
would exist.

The market value balance sheet shows that the total market value of a firm’s assets equals
the total market value of the firm’s liabilities, including all securities issued to investors.
Changing the capital structure therefore alters how the value of the assets is divided across
securities, but not the firm’s total value. - changes how you distribute the firm’s cash flows.

A firm can change its capital structure at any time by issuing new securities and using the
funds to pay its existing investors. An example is a leveraged recapitalization in which the
firm borrows money (issues debt) and repurchases shares (or pays a dividend).

MM Proposition I implies that such transactions will not change the current (cum
dividend) share price.

Initially, Harrison, an all-equity firm, has a market value of equity equal to the market value of
its existing assets, both amounting to $200 million. After borrowing $80 million, the liabilities
and assets increase by the same amount, keeping the equity value unchanged. Using the
borrowed cash, Harrison repurchases 20 million shares without altering the share price.
Although assets decrease by $80 million, maintaining balance, the market value of equity
falls to $120 million. Despite these changes, the zero-NPV transaction does not impact
shareholder value, and the share price remains at $4 per share.

Note: stock options (repurchase ) are not part of equity

Modigliani-Miller II: Leverage, Risk, and the Cost of Capital

MM Proposition I : E+D=U=A

Let E and D denote the market value of equity and debt if the firm is levered, respectively; let
U be the market value of equity if the firm is unlevered; and let A be the market value of the
firm’s assets.

We have the following relationship between the returns of levered equity (RE), debt (RD), and
unlevered equity (RU):

MM Proposition II: The cost of capital of levered equity increases with the firm’s market
value debt- equity ratio,
 =risk without leverage+additional risk of leverage
Debt is less risky than equity, so it has a lower cost of capital. Leverage increases the risk
of equity, however, raising the equity cost of capital.

The benefit of debt’s lower cost of capital is offset by the higher equity cost of capital,
leaving a firm’s weighted average cost of capital (WACC) unchanged with perfect
capital markets:

The market risk of a firm’s assets can be estimated by its unlevered beta. A measure of the
risk of a firm as if it did not have leverage, which is equivalent to the beta of the firm’s assets.
:
Leverage increases the beta of a firm’s equity- Leverage amplifies the market risk of a firm’s
assets, βU, raising the market risk of its equity:

A firm’s net debt is equal to its debt less its holdings of cash and other risk-free securities.
We can compute the cost of capital and the beta of the firm’s business assets, excluding
cash, by using its net debt when calculating its WACC or unlevered beta.

1st find the equity cost of unlevered beta for the initial debt. And then calculate the cost of
capital with that.

Capital Structure Fallacies

MM Propositions I and II state that with perfect capital markets, leverage has no effect on
firm value or the firm’s overall cost of capital. - 2 incorrect arguments that are sometimes
cited in favor of leverage:

●​ Criticism: Leverage can raise a firm’s expected earnings per share and its return on
equity.
Argument: But it also increases the volatility of earnings per share and the riskiness
of its equity. As a result, in a perfect market shareholders are not better off and the
value of equity is unchanged.
 ●​ Criticism: Issuing equity will dilute existing shareholders’ ownership, so debt financing
should be used instead.
●​ Dilution: An increase in total of shares that will divide a fixed amount of earnings

Argument: As long as shares are sold to investors at a fair price, there is no cost of
dilution associated with issuing equity. While the number of shares increases when
equity is issued, the firm’s assets also increase because of the cash raised, and the
per-share value of equity remains unchanged.

●​ Any gain or loss associated with the transaction will result from the NPVof the
investments the firm makes with the funds raised.

MM: Beyond the Propositions- Conservation of Value Principle for Financial Markets
●​ With perfect capital markets, financial transactions are a zero-NPV activity that
neither add nor destroy value on their own, but rather repackage the firm’s risk and
return. Capital structure— and financial transactions more generally—affect a firm’s
value only because of its impact on some type of market imperfection.

Chapter 15: Debt and Taxes

The Interest Tax Deduction
●​ Because interest expense is tax deductible, leverage increases the total amount of
income available to all investors.
●​ The gain to investors from the tax deductibility of interest payments is called the
interest tax shield.​

Interest Tax Shield = Corporate Tax Rate * Interest Payments

Note: Interest Expense- what the company pays for borrowing money (debt)

Valuing the Interest Tax Shield

When we consider corporate taxes, the total value of a levered firm equals the value of an
unlevered firm plus the present value of the interest tax shield.
Suppose a firm borrows debt D and keeps the debt permanently. If the firm’s marginal tax
rate is tc , and if the debt is riskless with a risk-free interest rate rf , then the interest tax shield
each year is tc * rf * D, and we can value the tax shield as a perpetuity:

The above calculation assumes the debt is risk free and the risk-free interest rate is
constant. These assumptions are not necessary, however. As long as the debt is fairly
priced, no arbitrage implies that its market value must equal the present value of the future
interest payments.

If the firm’s marginal tax rate is constant,4 then we have the following general formula:
When a firm’s marginal tax rate is constant, and there are no personal taxes, the
present value of the interest tax shield from permanent debt equals the tax rate times
the value of the debt, tc*D.

The WACC represents the effective cost of capital to the firm, after including the benefits of
the interest tax shield. It is therefore lower than the pre-tax WACC, which is the average
return paid to the firm’s investors. We have the following relationship between the after tax
WACC and the firm’s pre-tax WACC:

Recapitalizing to Capture the Tax Shield

When securities are fairly priced, the original shareholders of a firm capture the full benefit of
the interest tax shield from an increase in leverage.

Do not forget that the tax shield goes into assets and if the firm still hasn’t made the
repurchase of shares we need to add the cash of the debt towards assets.

Personal Taxes
Investors often face higher tax rates on interest income ti than on income from equity te,
offsetting the corporate tax benefit of leverage. The effective tax advantage of debt
incorporating investor level taxes can be estimated as

(1 - t*)(1 - ti) = (1 - tc)(1 - te)​

tc- corporate tax rate

For it to be a tax advantage t*>0

For it to be a tax disadvantage t*<0

If the net income is zero then tc=0

Optimal Capital Structure with Taxes

●​ The optimal level of leverage from a tax-saving perspective is the level such that
interest equals the income limit for the tax deduction. In this case, the firm takes full
advantage of the corporate tax deduction of interest, but avoids the tax disadvantage
of excess leverage at the personal level.
●​ The optimal fraction of debt, as a proportion of a firm’s capital structure, declines with
the growth rate of the firm.
●​ The interest expense of the average firm is well below its taxable income, implying
that firms do not fully exploit the tax advantages of debt.

Chapter 16: Financial Distress, Managerial

Incentives and Information
Default and Bankruptcy in a Perfect Market
●​ In the Modigliani-Miller setting, leverage may result in bankruptcy, but bankruptcy
alone does not reduce the value of the firm.
●​ With perfect capital markets, bankruptcy shifts ownership from the equity holders to
debt holders without changing the total value available to all investors.

The Costs of Bankruptcy and Financial Distress

●​ U.S. firms can file for bankruptcy protection under the provisions of the 1978
Bankruptcy Reform Act.
○​ Liquidation - a trustee oversees the liquidation of the firm’s assets.
 ○​ Reorganization - management attempts to develop a reorganization plan that
will improve operations and maximize value to investors. If the firm cannot
successfully reorganize, it may be liquidated under bankruptcy.

●​ Bankruptcy is a costly process that imposes both direct and indirect costs on a firm
and its investors.
○​ Direct costs include the costs of experts and advisors such as lawyers,
accountants, appraisers, and investment bankers hired by the firm or its
creditors during the bankruptcy process.
○​ Indirect costs include the loss of customers, suppliers, employees, or
receivables during bankruptcy. Firms also incur indirect costs when they need
to sell assets at distressed prices.

Financial Distress Costs and Firm Value - When securities are fairly priced, the original
shareholders of a firm pay the present value of the costs associated with bankruptcy and
financial distress.
Always find NI and then divide by the number of shares outstanding. the big difference of it
being financed with or without debt is that if it is financed with debt you add to your NI the tax
shield.

Optimal Capital Structure: The Tradeoff Theory

■ According to the tradeoff theory, the total value of a levered firm equals the value of the
firm without leverage plus the present value of the tax savings from debt minus the present
value of financial distress costs:

VL = VU + PV(InterestTaxShield) - PV(FinancialDistressCosts)
Optimal leverage is the level of debt that maximizes VL.

Three key factors determine the present value of financial distress costs:

(1) the probability of financial distress (likelihood that a firm will be unable to meet its debt
commitments and therefore default) - increases with the amount of liabilities

(2) the magnitude of the costs if the firm is in distress - depend on the relative importance of
costs

●​ Technology firms, whose value comes largely from human capital, are likely to incur
high costs when they risk financial distress, due to the potential for loss of customers
 and the need to hire and retain key personnel, as well as a lack of tangible assets
that can be easily liquidated.
●​ Firms whose main assets are physical capital, such as real estate firms, are likely to
have lower costs of financial distress, because a greater portion of their value derives
from assets that can be sold relatively easily.

(3) the appropriate discount rate for the distress costs - depend on the firm’s market risk

●​ The present value of distress costs will be higher for high beta firms.

Want to finance more with debt if you know it has lower distress costs.

Calculating Financial Distress Costs

Exploiting Debt Holders: The Agency Costs of Leverage

■ Agency costs arise when there are conflicts of interest between stakeholders. A highly
levered firm with risky debt faces the following agency costs:
●​ Asset substitution: Shareholders can gain by making negative-NPV investments or
decisions that sufficiently increase the firm’s risk.
○​ Shareholders, seeking higher returns, might take on projects or actions that
benefit them individually but are detrimental to the overall value of the firm.
This can lead to a misalignment of interests between shareholders and
debtholders.
●​ Debt overhang: Shareholders may be unwilling to finance new, positive-NPV
projects.
○​ In highly leveraged firms, shareholders may prioritize reducing debt to avoid
financial distress, which can result in missed opportunities for positive NPV
projects. This conflict arises from the different risk preferences of
shareholders and debtholders.
●​ Cashing out: Shareholders have an incentive to liquidate assets at prices below their
market values and distribute the proceeds as a dividend.
○​ Shareholders might choose to sell off assets at prices below their actual
market values to extract cash from the firm, possibly to the detriment of
 debtholders. This behavior can result in wealth transfer from debtholders to
shareholders.
Agency costs : expected payoff of the project you would choose if you had no
leverage- expected payoff of the project you would choose with the leverage

●​ With debt overhang, equity holders will benefit from new investment only if​

●​ When a firm has existing debt, debt overhang leads to a leverage ratchet effect:
The leverage ratchet effect refers to a situation in which a firm with existing debt
faces challenges in adjusting its capital structure due to the reluctance of
shareholders to reduce leverage, even when it would be economically beneficial for
the firm.

○​ Shareholders may have an incentive to increase leverage even if it decreases

the value of the firm.
When a firm is highly leveraged, shareholders might find it advantageous to
take on additional debt, especially if they believe the negative impact on the
firm's value is outweighed by the benefits to their own interests. This could
involve extracting cash or using the funds for purposes that benefit
shareholders at the expense of other stakeholders, such as debtholders.

○​ Shareholders will not have an incentive to decrease leverage by buying back

debt, even if it will increase the value of the firm.
In a situation of debt overhang, shareholders might refrain from buying back
debt to reduce leverage, even if it is economically rational to do so. ​

Motivating Managers: The Agency Benefits of Leverage

The separation of ownership and control creates the possibility of management

entrenchment: facing little threat of being fired and replaced, managers are free to run the
firm in their own best interests.

■ Leverage has agency benefits and can improve incentives for managers to run a firm more
efficiently and effectively due to
​ ■ Increased ownership concentration: Managers with higher ownership
concentration are more likely to work hard and less likely to consume corporate
perks.
​ ■ Reduced free cash flow: Firms with less free cash flow are less likely to pursue
wasteful investments.
​ ■ Reduced managerial entrenchment and increased commitment: The threat of
financial distress and being fired may commit managers more fully to pursue
strategies that improve operations.
Agency Costs and the Tradeoff Theory
■ We can extend the tradeoff theory to include agency costs. The value of a firm, including
agency costs and benefits, is:
V L = V U + PV ( Interest Tax Shield) - PV ( Financial Distress Costs) -PV (Agency Costs of
Debt) + PV (Agency Benefits of Debt)
Optimal leverage is the level of debt that maximizes V L.

Asymmetric Information and Capital Structure

■ When managers have better information than investors, there is asymmetric information.
Given asymmetric information, managers may use leverage as a credible signal to investors
of the firm’s ability to generate future free cash flow.
■ According to the lemons principle, when managers have private information about the
value of a firm, investors will discount the price they are willing to pay for a new equity issue
due to adverse selection.
■ Managers are more likely to sell equity when they know a firm is overvalued. As a result,
​ ■ The stock price declines when a firm announces an equity issue.
​ ■ The stock price tends to rise prior to the announcement of an equity issue
because managers tend to delay equity issues until after good news becomes
public.
​ ■ Firms tend to issue equity when information asymmetries are minimized.
​ ■ Managers who perceive that the firm’s equity is underpriced will have a
preference to fund investment using retained earnings, or debt, rather than
equity. This result is called the pecking order hypothesis.​

Capital Structure: The Bottom Line

■ There are numerous frictions that drive the firm’s optimal capital structure. However, if
there are substantial transaction costs to changing the firm’s capital structure, most changes
in the firm’s leverage are likely to occur passively, based on fluctuations in the firm’s stock
price.
Exercise Lecture

If you have two companies that generate the same CFs and you have a portfolio of 1% of a
company without debt, you can get the same cash flow by holding 1% of the debt and 1% of
the equity of a similar firm.

Tutorial Week 5

The leveraged buyout of Hilton Hotels

Case overview & background

Jon Gray, the head of Blackstone’s Real Estate Group, sourced one of the most
ambitious and largest transactions the firm had undertaken: the acquisition of Hilton
Worldwide (formerly Hilton Hotels).

Evaluating investment opportunities requires financial managers to estimate the cost

of capital. For example, when executives at Blackstone evaluate a capital investment
project, such as the acquisition of Hilton, they must estimate the appropriate cost of
capital for the project in order to determine its NPV. The cost of capital should include
a risk premium that compensates Blackstone’s investors for taking on the risk of the
new project. The complexity of the deal structure, the target transaction, and the level
of capital commitment required to execute the deal, required various stakeholders to
not only agree on the investment but​
also to provide additional value-added management and funding post-acquisition,
making it a monumental decision for Blackstone. As such, the level of due diligence,
financial engineering, and investment analysis required in order to execute the
transaction was considerable.

Part of the investment process of transactions of this size entails a thorough analysis
and due diligence prior to the execution of a deal. As such, you are tasked with
calculating a number of important figures that will help provide insights regarding the
Blackstone acquisition of Hilton.

Overview of Hilton Hotel's financials:

●​ Short-term debt: $37,000,000

●​ Long-term debt: $7,956,000,000
●​ Cash & cash equivalents: $538,000,000
●​ Current share price: $85
●​ Shares outstanding: 278,985,125
●​ Cost of equity: 6%
●​ Cost of debt: 4%
●​ EBIT: $1,658,000,000
●​ Tax rate: 25%

Financial Analysis & Valuation

Valuation Analysis – Price Hilton at the time of purchase assuming no capital injections
from Blackstone.​
For the following questions, always assume a perfect capital market (no
corporate/personal taxes).

1.​ What is Hilton’s EV (Enterprise Value)? Use the relevant figures on its share
price, shares outstanding, and debt.
enterprise value= market value equity + market value debt - cash
enterprise value= FCF1/(1+r) + FCF2/(1+r)^2+...
EV= (SO*Current Share Price)- Cash Equivalents + Debt
2.​ What fraction of Hilton’s value is financed by debt?
D-Cash Equivalents/EV
3.​ What is Hilton’s current WACC? How much is the WACC lowered due to the
presence of the corporate tax?
 4.​ What if the firm had twice its current debt, how would it affect its cost of
debt? Would it also affect its cost of equity and, if so, how?

yes because \

re increases by more than rd

5.​ What would be an advantage of using more debt? What would be a
disadvantage?
More interest tax shield
Risk increases
higher expected cost of financial distress
Personal taxes are a disadvantage
6.​ What is a clear motivation for an acquirer to choose a leveraged buyout?
Why would an acquirer want to use such high levels of debt?
growth in the operating profit over the life of the investment
higher profit- higher value

amount of debt that is paid iff iver the time horizon of the investment- good for inflation
Doubts

Do not get why they don’t take the expected value

Aren’t stock options part of equity- question b ?

For b why didn’t they count with the issuing of 100 million of preferred stock

Shouldn’t we also count with the net debt so d/e+d= -25/103?

where is that formula?

how did they find E+D ?

If the risk of debt increases, rd will increase, shouldn’t re decrease

do not get 3 at all

i do not get why in c they used the 2.85 instead of 3
How do they do c? Do we only have a tax advantage if NI is positive?

Is interest tax shield part of equity, debt or asset?

I don’t get b and why is the expected return equal to 0.05(is it law of one price) and lastly d?

For a why did they not account for the 15 million debt too?
do not understand what they did

●​ equity holders will benefit from new investment if the previous

happens
For project B why didn’t they do 0.5(100)+ (0.5*-40). They just change negative expect
payoffs to 0 and i don’t understand why?

Things to remember: Chapter 14

1st: NPV is different from the value of equity

NPV: Costs- Expected returns

Equity: Expected Returns- if unlevered
Expected Returns - (any debt that might be incurred) -if levered

To calculate the return of equity: value of the firm not discounted- debt /value of the firm
discounted (14-3)

Note: if we pay an annual interest on debt account for debt payment as just the interest

How to find arbitrage opportunities: 1st find which option is overpriced

sell all the shares of the overpriced option
and see how much money you get
When discovering the cost of capital after a recapitalization- first calculate it before

It does not matter what a firm does with the money after getting it (like dividend payments) it
just matters if it is debt (it was borrowed) or equity (sold shares) or assets (cash)

Do not forget that you might not have debt, but if you have cash it counts as debt when you
think about net debt

Chapter 15:

to calculate assets
no recapitalization yet
1st step- find unlevered value of your firm (always equal to assets)
declaration of debt but haven’t repurchased shares yet
2nd step - take the asset value and add the cash you received from borrowing and add the
interest tax shield

note: in order to find price of shares- need to divide equity

If you have an interest tax shield the value of your assets that is equal to the value of your
unlevered firm is gonna equal Equity + debt + int.tax shield