St.

Mary’s University Department of Accounting

Chapter 4
Capital Structure Policy and Leverage
The capital structure question

It is a question of how should a firm go about choosing its debt/equity ratio. Is there an optimum
capital structure that maximizes firm’s value? Capital structure and cost of capital relationships. The
value of the firm is maximized when the WACC is minimized. WACC is the discount rate that is
appropriate for the firm’s overall cash flows and values and discount rate move in opposite
directions, minimizing the WACC will maximize the value of the firm’s cash flows.

Business and Financial risk

Business risk is defined as the equity risk that comes from the nature of the firm’s operating
activities. Business risk depends on the systematic risk of the firm’s asset. The greater a firm’s
business risk, the greater RA will be, and, all other things the same, the greater the will be its cost of
equity.

There are two kinds of leverage in finance: operating leverage and financial leverage

Operating Leverage

Operating leverage refers to magnifying gains and losses in earnings before interest and taxes (EBIT)
by changes that occur in sales. This magnification occurs because in employing assets the firm incurs
certain fixed costs, costs unrelated to the sales volume created by the assets. Operating costs can be
divided into variable and fixed costs. As sales changes, variable costs change proportionally. This
means the variable cost ratio to sales is constant. This is true over some relevant range of sales.
Variable cost includes material, direct labor, repair and maintenance expenses. Fixed operating costs
are independent of sales level in the short run and over the relevant sales range. In the long run all
costs are variable. Fixed costs include depreciation, indirect labor cost, overhead costs.

Degree of Operating Leverage (DOL)

Degree of operating leverage is computed as:

DOL= %ΔEBIT
%Output where, EBIT is earning before interest and tax
Or
=1+ F
EBIT where, F is fixed operating cost
Or
DOL at base sales level Q = Q(P-V)
Q(P-V)-F where, Q is quantity, P is price ,
V is variable cost and F is fixed cost

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Example
P= 10 birr
V= 4 birr
F= 30,000 birr
Level of out put (Q) is 8,000 and increase to 10,000 units.

Required:
Determine DOL?

Solution:
EBIT = Q (P-V)-F
=8000(10-4)-30,000 = 18,000
EBIT = 10,000 (10-4)-30,000=30,000

Percentage change in EBIT= (30,000-18,000)/18,000=66.67%

Percentage change in out puts = (10,000-8,000)/8,000=25%

DOL= % ΔEBIT

% Output
66.67%/25%=2.67
Or
1+ F
EBIT
1+ 30,000/18,000=2.67
Or
= Q(P-V)
Q (P-V) - F
=8,000(10-4)
8,000(10-4)-30,000
=2.67

The coefficient of operating leverage of 2.67 is interpreted as a 1% change in out put form the
current base levels, there will be a 2.67% change in EBIT in the same direction as the out put (sales)
change. If out put (sales) increase by 10%, EBIT will increase by 26.7% (10x 2.67%). Similarly, if out
put (sales) decrease by 10%, EBIT will decrease by 26.7%. Other things equal, the higher the fixed
costs relative to variable costs, the higher the operating leverage.

Example: AA firm has a base level of 150,000 units of sales. The sales price per unit is $10.00 and
variable costs per unit are $6.50. Total annual operating fixed costs are $155,000, and the annual
interest expense is $90,000. What is this firm’s degree of operating leverage (DOL)?

Solution:

DOL = Q (P-V) = 150,000(10-6.50)

Q (P-V) - F = 150,000(10-6.50)-150,000
= 1.4

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Breakeven analysis:

The sales level that corresponds with a zero EBIT level is called the break-even sales level.

EBIT= SALES- VARIABLE COST- FIXED COST

0 =P.Q-V.Q-FC
0 = Q(P-V)-FC
Q (P-V) = FC

Q = FC
P-V

Example
P = 10
V=4
FC = 90,000
Required: Determine operating break even in units and sales?
Q = FC
P-V
= 90,000/ (10-4) = 15,000 units. Sales = 10x 15,000 =150,000

Note that the coefficient of operating leverage at operating break even has undefined value.

Example: Compute EBIT and coefficient of operating leverage when Q is 10,000 units?

Solution:
EBIT= Q (P-V)-F = 10,000 (10-4) - 90,000 = (30,000)
DOL = Q (P-V) = 10,000 (10-4)
Q (P-V)-F 10,000 (10-4) - 90,000
=2
Or
DOL =1+ F = 1 + 90,000
EBIT (30,000)
1-3= 2

Note: - Technically, the formula for DOL should include absolute value signs because it is possible to get
a negative DOL when the EBIT for the base sales level is negative. Since we assume that the EBIT for the
base level of sales is positive, the absolute value signs are not included.
Because the concept of leverage is linear, positive and negative changes of equal magnitude

Break even analysis limitation:

1. There is a narrow range of sales over which expects fixed costs to be actually fixed.
2. It is only helpful when there is linear relationship among variable, EBIT and sales.

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Financial risk and financial leverage

Financial Leverage
Operating leverage refers to the fact that a lower ratio of variable cost per unit to price per unit
causes profit to vary more with a change in the level of output than it would if this ratio was higher.
Financial leverage refers to the fact that a higher ratio of debt to equity causes profitability to vary
more when earnings on assets changes than it would if this ratio was lower. Obviously, the profits of
a business with a high degree of both kinds of leverage vary more, everything else remaining the
same, than do those of businesses with less operating and financial leverage. Greater variability of
profits, of course, means risk is higher. Therefore, in deciding what the optimum level of leverage is,
what is an acceptable risk/return tradeoff must be determined.

Financial leverage is created by financing with sources of capital that have fixed costs.
The major sources of fixed charges financing are debt (requiring interest payment) and preferred
stock require dividend payment and leases which require lease payments. These financing fixed
costs affect the firm’s earning per share (EPS) in the same way that operating fixed costs affect EBIT.
The more fixed charge financing the firm uses, the more financial leverage it will have.

Degree of Financial leverage:

Degree of financial leverage is defined as the percentage change in EPS divided by the percentage
change in EBIT.
DFL = %Δ in EPS
%Δ in EBIT
Where, EPS is earning per share

EPS = (EBIT-I) (1-T)-D

N
Where, N is number of common stock outstanding shares.

Or
DFL = EBIT
EBIT-I-L-D/ (1-T)
Where, I is interest payment
L is lease payment
D is dividend payment
T is tax rate

Unlike interest and lease payments, preferred dividends are not tax deductible. Therefore, dividend
payment has to be adjusted by dividing with (1-T) to make it on equivalent basis.

Example: A firm has a base level of 500,000 units of sales and increase to 600,000 units. The sales
price per unit is $10.00 and variable costs per unit are $6.50. Total annual operating fixed costs are
$1,250,000, and the annual interest expense is $100,000. The firm paid 80,000 for preferred stock
holders and has 60,000 outstanding shares of common stock. The firm tax rate is 40%.
1. What is the firm’ earning per share?
2. What is the firm’s degree of financial leverage (DFL)?
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Solution:

1. EPS = (EBIT-I) (1-T)-D

N
EBIT = 500,000(10-6.50)-1,250,000=500,000
EPS = (500,000-100,000) (1-0.4)-80,000
60,000
= 2.67
If sales increases from 500,000 to 600,000 units the resulting EBIT and EPS is:
EBIT = 600,000(10-6.50)-1,250,000=850,000
EPS = (850,000-100,000) (1-0.4) - 80,000
60,000
=6.16
DFL = %Δ in EPS
%Δ in EBIT

= (6.16-2.67)/2.67
(850,000-500,000)/500,000
=1.307/0.7= 1.87
Or
DFL = EBIT
EBIT-I-L-D/(1-T)
= . 500,000 .
500,000-100,000- 80,000/(1-0.4)
=1.87

Financial break even

It is defined as the value of EBIT that makes EPS equal to zero. At financial break even, the firm’s
EBIT is just sufficient to cover its fixed financing costs (interest and preferred Stock dividends) on a
before tax basis leaving no earnings for common shareholders.

(EBIT-I)(1-T)-D= EPS
N
(EBIT-I)(1-T)-D= 0 (EBIT-I) (1-T)-D = 0
N EBIT-I = D EBIT= D +I
(1-T) (1-T)
2.3.3 Combined leverage
It is defined as the potential use of fixed costs, both operating and financial, to magnify the effect of
changes in sales on the firm’s earnings per shares (EPS). It is a combination of operating and
financial leverage. Combined leverage measures the relationship between output and EPS.
Degree of combined leverage (DCL) = %Δ in EPS
%Δ in output DCL = DOL X DFL
or The DCL is the product of DOL times DFL. That is: = Q (P-V) x EBIT
Q (P-V)-F EBIT-I-L-D/(1-T)
DCL = DOL X DFL Or = Q (P-V)
Q (P-V)-F-I-L-D/ (1-T)

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Example: A firm has a base level of 15,000 units of sales and increase to 16,500 units. The sales price
per unit is $50.00 and variable costs per unit are $30. Total annual operating fixed costs are
$150,000, and the annual interest expense is $40,000. The firm paid 20,000 for preferred stock
holders and has 10,000 outstanding shares of common stock. The firm tax rate is 40%.

1. What is the firm’ earning per share at an output level of 15,000 and 16,500 units?
2. What is the firm’s EBIT, Degree of operating leverage (DOL) and degree of financial leverage at
output level of 15,000 (DFL)?
3. What is the firm’s Degree of combined leverage( DCL)?

Solution:
EPS = (EBIT-I) (1-T)-D
N
EBIT = 15,000(50-30)-150,000=150,000
EPS = (150,000-40,000) (1-0.4) - 20,000
10,000
= 4.6
If output increased to 16,500 units, EPS increase to:
EPS = (EBIT-I) (1-T)-D
N
EBIT = 16,500(50-30)-150,000=180,000
EPS = (180,000-40,000) (1-0.4) - 20,000
10,000
= 6.4
DCL = %Δ in EPS
%Δ in output
= (6.4-4.6)/4.6
(16,500-15,000)/15,000
= 3.91

DOL =1+ F = 1 + 150,000

EBIT 150,000
1+1= 2

DFL = EBIT
EBIT-I-L-D/(1-T)
= . 150,000 .
150,000-40,000- 20,000/ (1-0.4)
= 1.957
Therefore, DCL = DOL X DFL
=2 x 1.957
=3.91

Note: the firm’s DCL describes the effect that sales changes will have on EPS. However, we must be
careful to realize the approximate nature of this calculation. If the anticipated sales change is beyond
the relevant range of sales describe earlier, the variable cost ratio may change, and if the time period
is too long, fixed costs may change.

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Overall breakeven
It is defined as the level of output that makes EPS equal to zero.
EPS = (EBIT-I) (1-T)-D
N
0 =[Q(P-V)-F – I)] (1-T)- D
N
Q = I + F+ D/ (1-T)
P- V

Example: A firm has a base level of 15,000 units of sales. The sales price per unit is $50.00 and
variable costs per unit are $30. Total annual operating fixed costs are $150,000, and the annual
interest expense is $40,000. The firm paid 20,000 for preferred stock holders and has 10,000
outstanding shares of common stock. The firm tax rate is 40%. What is the overall breakeven unit?

Solution: Q = I + F+ D/ (1-T)
P- V
= 40,000 + 150,000 + 20,000/(1-0.4)
(50-30) = 11,167 units

Financial leverage and Capital structure

Optimal capital structure is the capital structure that minimizes the firm’s weighted average cost of
capital and maximizes the value of the firm to its investors. If the firm currently has an optimal
capital structure, it will finance new investments by a financing mix approximately like the current
mix. If the current capital structure is not optima, the firm should finance new asset in such a manner
that the capital structure will be moved toward the optimal position.

Effect of Financial leverage on EPS

Example: Suppose, a new firm, ABC Company, is just now considering financing plans. The firm
needs birr 100,000 of long term capital to begin operations and has narrowed the choice to two
financing plans:
Alternative 1: sell 1,000 shares of common stock at birr 100 per share.
Alternative 2: sell 500 shares of common stock at birr 100 per share and borrow birr 50,000 from
the bank at 5% interest.

Alternative 1 is an all equity plan. The company’s long term debt to equity ratio would be zero.
Alternative 2 involves the sales of equal amounts of debt and equity, and the firm’s long-term debt to
equity ratio to be one.

What effect would these plans have on ABC’s EPS? It depends on the relationship between the before
tax cost of debt and the rate of return on assets before interest and taxes. Most firm’s EBIT influenced
by general economic conditions. If the economy is strong, EBIT will be favorable, and if the economy
is weak, EBIT will be unfavorable. ABC estimates that if the economy is weak, EBIT will be 4,000; if
the economy is about average, EBIT will be birr 6,000; and if the economy is strong, EBIT will be birr
8,000. Theses estimates imply that ABC’s return on asset before interest and tax (EBIT/ Total asset)
will be 4%(4,000/100,000) in weak economy, 6 percent in an average economy, and 8 percent in a
strong economy. In comparison, the before tax cost of debt is 5%.

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Economic conditions
Weak Average Strong
Alternative 1: all equity financing (debt: equity ratio=0)
EBIT 4,000 6,000 8,000
INTEREST 0 0 0
EBT 4,000 6,000 8,000
TAX(50%) 2,000 3,000 4,000
NI 2,000 3,000 4,000
NO OF SHARES COMMON 1,000 1,000 1,000
EPS 2 3 4

Alternative 2: 50% equity and 50% debt financing (debt: equity ratio=1)
EBIT 4,000 6,000 8,000
INTEREST 2,500 2,500 2,500
EBT 1,500 3,500 5,500
TAX(50%) 750 1,750 2,750
NI 750 1,750 2,750
NO OF SHARES COMMON 500 500 500
EPS 1.5 3.5 5.5

Indifference point EBIT- EPS analysis:

The effect of financial leverage on EPS depends on the relationship between the before tax cost of
debt and the EBIT rate of return on assets.
In a weak economy, EPS is higher under the all equity alternative. But in either an average or a strong
economy, EPS pf alternative 2 is higher. Actually, alternative 2 will result in higher EPS so long as
EBIT/ TA are greater than the before tax cost of debt of 5%

Alternative 2

Alternative 1
5
EPS 4
3
2
1
0 1 2 3 4 5 6 7 8
EBIT (Birr 000)
Figure 2.1
We can also algebraically solve for EBIT at the indifference point. By definition:
EPS = (EBIT-I) (1-T)-D
N
Alternative 1: EPS 1 = (EBIT-0) (1-0.5)-0 = 0.0005 EBIT
1,000
Alternative 2: EPS 2 = (EBIT-2,500) (1-0.5)-0 = 0.0001 EBIT-2.5
500
The indifference point is where the two EPS’ are equal.
0.0005 EBIT = 0.0001 EBIT - 2.5 => EBIT= 5,000birr

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Effect of financial leverage on financial risk and expected EPS

In this section we relate expected EPS and financial risk to stock price. Let us assume ABC’s EBIT
outcomes are equally likely, and then the probability of each is one third.
EPS
EBIT Probability Alternative 1 Alternative 2
4,000 1/3 2 1.50
6,000 1/3 3 3.50
8,000 1/3 4 5.50
Required: compute expected EPS and standard deviation of each alternative.

Expected EPS = EPS x Probability

Alternative 1: expected EPS= 1/3 x 2 + 1/3x 3 + 1/3x 4 =3

Standard deviation= 1/3(2-3)2 + 1/3(3-3)2 + 1/3(4-3)2
=0.82

Alternative 2: expected EPS= 1/3 x 1.5 + 1/3x 3.50 + 1/3x 5.5 =3.50
Standard deviation= 1/3(1.5-3.5)2 + 1/3(3.5-3.5)2 + 1/3(5.5-3.5)2
=1.63

When we see the two alternatives, note that there are two effects of financing with debt. That is there
are two effects of financial leverage:
1. Expected earnings per share increases
2. The standard deviation of earnings per share increases. These two conclusions have
important valuation implications. The firm’s ability to pay dividend is directly related to its
expected EPS. The greater the expected EPS, the greater the firm’s future expected dividends
will be.
Remark: increased financial leverage = increase expected EPS = increase standard deviation
=increase stock riskiness.

The theory of capital structure

There are two views regarding capital structure and firm value: the traditionalists’ view and
modernists’ view.

Traditionalists believe that as a firm moves from a position of zero debt to small amounts of debt,
leverage increases the equity holders’ risk but does not increase significantly the risk born by debt
holders. Traditionalist argued that because debt is cheaper, combining equity with reasonable
amounts of debt results a reduction in the firm’s overall cost of capital, or rA.

Traditionalists believe that too much debt can be bad thing. Look at what happens to the cost of debt
and equity as debt levels go from low to high. First, the cost of debt, which initially did not raise
much, now starts to rise substantially as debt holders become highly concerned about the firm’s
ability to generate enough income to cover promised debt payments. Second, at high debt levels, the
cost of equity also rise quickly because equity holders know that high amounts of debt are
accompanied by high amounts of fixed interest payment, increasing the chance that they as residual
claimants will end up with little or no return on their investment, thus, following the traditionalists’
argument, the overall cost of capital of the firm begins to rise at high levels of debt

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rE

Rate of return rA

rD

Optima amount of Debt

D*
Figure 2.2 Debt as percentage of Total asset

Figure 2.2 illustrates the traditionalists’ view on the effect of leverage on the expected return of both
the debt holder and the equity holder. The line rD represents the cost of debt, the line rA is the
expected rate of return on assets, and the line rE is the cost of equity. D* is debt capacity, the range of
debt that minimizes the firm’s cost of capital and maximizes the firm value.

The modernists’ position on the use of debt and the value of the firm was established by Franco
Modigliani and Merton Miller in the late 1950s. The modernist position states that, under ideal
conditions, all capital structures produce the same total cost of capital to the firm and the same total
firm value. Modernists believe that the financing decision is irrelevant.

rE
Rate of return

rA
rD

Debt as percentage of Total asset

Figure 2.3

There is no dramatic point at which the cost of equity rapidly rises. The required rate of return on
equity rises less quickly when greater debt usage begins to transfer some of the firm’s risk to the
debt holders. The required return on equity (rE) begins to flatten out or rise less steeply at higher
levels of debt. This reflects the fact that as debt holders begin to bear more and more risk, the
increased risk borne by equity holders is reduced. With the modernist view there is no optimum
capital structure and firms do not have debt capacity.

Modigliani and Miller (M&M) Propositions I and II with no taxes

It is a famous argument advanced by two Nobel laureates, Franco Modigliani and Merton Miller,
whom we will hence forth call M&M.

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A) M&M Proposition I: The Pie Model

Proposition I states that the value of the firm is independent of its capital structure. M&M
proposition I is to imagine two firms that are identical on the left hand side of balance sheet. Their
assets and operations are exactly the same. The right hand sides are different because the two firms
finance their operations differently. It can be view the capital structure in pie model. As we can see in
figure 2.4, two possible ways of cutting up the pie between equity slice and debt slice 40%-60% and
60%-40%. However, the size of the pie is the same for both firms because the value of the assets is
the same. This is what M&M Proposition I states: The size of the pie doesn’t depend on how it is sliced.

Value of firm Value of firm

Stock Stock
40% 60%

Bonds Bonds
60% 40%

Figure 2.4

B) M&M Proposition II: The Cost of Equity and Financial Leverage.

Although changing the capital structure of the firm may not change the firm’s total value, it does
cause important changes in the firm’s debt and equity. Let us see what happens to a firm financed
with debt and equity when the debt/equity ratio is changed.

M&M proposition II stated that weighted average cost of capital, WACC, is:

WACC= E/V x RE + D/V x RD

Where V= E + D
E= equity
D= debt
RE= cost of equity
RD= cost of debt

WACC is the required return on the firm’s overall assets and it is also labeled as RA

RA = E/V x RE + D/V x RD, if we arrange this to solve for the cost of equity capital (RE):

RE = RA + (RA- RD) x (D/E)

M&M proposition stated that a firm’s cost of equity capital is a positive linear function of its capital
structure. The cost of equity depends on three things: the required rate of return on the firm’s assets,
RA, the firm’s cost of debt, RD, and the firm’s debt/equity ratio, D/E

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RE

Cost of capital

WACC= RA

RD

Figure 2.5 Debt/Equity ratios (D/E)

As shown M&M proposition II indicates that the cost of equity, RE, is given by the straight line
with a slope of (RA-RD). The y-intercept corresponds to a firm with a debt/equity ratio of zero, so
RA=RE. As the firm raises its debt/equity ratio, the increase in leverage raises the risk of the
equity and therefore the required return or cost of equity (RE). Notice that the WACC doesn’t
depend on the debt/equity ratio; it’s the same no matter what the debt/equity ratio is. The firm’s
overall cost of capital is unaffected by its capital structure. As illustrated in figure 2.5, the fact that
the cost of debt is lower than the cost of equity is exactly offset by the increase in the cost of
equity form borrowing. In other words, the change in the capital structure weights (E/V and D/V)
is exactly offset by the change in the cost of equity (RE), so the WACC stays the same.

Example: The RRR Corporation has a weighted average cost of capital (unadjusted) of 12
percent. It can borrow at 8 percent. Assume that RRR has a target capital structure of 80 percent
equity and 20 percent debt.

Required:
1. What is its cost of equity?
2. What is the cost of equity if the target capital structure is 50 percent equity?
3. Calculate the unadjusted WACC using your answers to verify that it is the same

Solution:
1. According to M&M proposition II,
RE = RA + (RA- RD) x (D/E)
=12% + (12%-8%) x (0.2/0.8)
=13%
2. RE = RA + (RA- RD) x (D/E)
=12% + (12%-8%) x (0.5/0.5)
=16%

3. The unadjusted WACC assuming that the percentage of equity financing is 80% and the cost of
equity is 13%:

WACC = E/V x RE + D/V x RD

= 0.8 x 13% + 0.2 x 8%
=12%

As we calculated, the WACC is 12 percent in both cases.

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Exercise1: The FFF company, a major manufacturer of telephone switching equipment, has a
perpetual expected EBIT of birr 200. The interest rate is 12%.

Required:
1. Assuming that there are no taxes or other market imperfections, what is the value of the
company if its debt/equity ratio is 0.25 and its overall cost of capital is 16%? What is the value
of the equity? What is the value of the debt?
2. What is the cost of equity capital for the company?
3. Suppose the corporate tax rate is 30%, there are no personal taxes or other imperfections,
and FFF Company has birr 400 in debt outstanding. If the unlevered cost of equity is 20%,
what is FFF’s value? What is the value of the equity?
4. In question number 3, what is the overall cost of capital?

Solution
1. If there are no taxes, then MM proposition I holds and FFF’s capital structure is irrelevant, so
the value of the firm is (birr 200/0.16)= birr 1250.
If the debt/equity ratio is 0.25, then for every birr 5 in capital, there is birr 4 in equity. Thus,
FFF is 80% equity, and the value of the equity is birr 1000. The value of the debt is birr 250

2. the cost of equity capital can be computed using MM Proposition II as:

RE = RA + (RA- RD) x (D/E)
=16% + (16%-12%) x 0.25
=17%

Alternatively, we can compute the equity cash flow as (birr 200-0.12(250)) = birr 170, and divide by
the value of equity. Since the equity is worth birr 1000, the cost of capital is (birr 170/1000) =0.17
=17%

3. We can use MM Proposition I with taxes to value FFF.

VL= VU + Tc x D

The value of FFF as an unlevered firm is:

EBIT (1-Tc)/ro= (birr 200 (1-0.3)/0.2= birr 700. The present value of the tax shield is Tc x D=
(0.3(400)) = birr 120. The total value of the levered is therefore birr 820. The value of the equity is
(birr 820- birr 400) = birr 420.

4. Using MM Proposition II with taxes, the cost of equity is:

RE= RU + (RU-RD) x D/E x (1-Tc)
=20%+ (20%-12%) x 400/420 x (1-0.3)
= 25.33%

Alternatively, the cash flow to equity is:

(Birr 200-0.12(birr400)) (1-0.3) = birr 106.40

Thus, the return on equity is (birr 106.40/ birr 420) = 0.2533 or 25.33%, as previously calculated.
The over all cost of capital (WACC) is;
WACC= E/V x RE + D/V x RD (1-TC)
= (420/820) x 25.33% + (400/820) x 12% x (1-0.3) = 17.07%

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Modigliani and Miller (M&M) Propositions I and II with taxes

Debt has two features. First, interest paid on debt is tax deductible. This is good for the firm. Second,
failure to meet debt obligations can result in bankruptcy. This is not good for the firm, and it may be
an added cost of debt financing. To see the effect of tax on M&M Propositions let us consider two
firms, Firm U (unlevered) and Firm L (levered). These two firms are identical on the left hand side of
the balance sheet, so their assets and operations are the same. Assume that EBIT is expected to be
birr 1000 every year forever for both firms. The difference between them is that firm L has issued
birr 1000 worth of perpetual bonds on which it pays 8 percent interest each year. Also assume that
the corporation tax rate is 30%.

Firm U Firm L
EBIT birr 1,000 birr 1,000
Interest (8% x 1000) 0 80
EBT 1,000 920
Tax (30%) 300 276
NI 700 644

The interest tax shield

To simplify things, assume that depreciation is zero and that there is no additional capital
expenditure and net working capital. In this case, cash flow from assets is equal to EBIT- Taxes. For
firms U and L the cash flow from assets would be birr (1000-300=700) and (1000-276=724),
respectively. See that the capital structure is now having some effect because the cash flows from U
and L are not the same even though the two firms have identical assets. The total cash flow to L is
birr 24 more. This is because an interest deductible for tax purposes has generated a tax saving equal
to the interest payment multiplied by the tax rate: 80 x 30% = birr 24. This is interest tax shield, a tax
saving attainted by a firm from interest expense.

A. Taxes and M&M Proposition I

Since the debt is perpetual, the same birr 24 shield will be generated every year forever. The after tax
cash flow to L will thus be the same birr 700 that U earns plus the birr 24 tax shield. Since L’s cash
flow is always birr 24 greater, firm L is worth more than Firm U by the value of this birr 24
perpetuity. Because the tax shield is generated by paying interest, it has the same risk as the debt,
and 8 percent (the cost of debt) is therefore the appropriate discount rate. The value of the tax shield
is thus:

PV= birr 24/0.08 = 0.3 x 1,000 x 0.08

0.08
= 0.3(1000) = 300
The present value of the interest tax shield can be written as:

PV = (Tc x RD x D)
RD
PV = Tc x D
Where, Tc is tax rate, RD is cost of debt and D is debt

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St. Mary’s University Department of Accounting
We have now come up with another famous result, M&M Proposition I with taxes. We have seen that
the value of levered firm (VL) exceeds the value of unlevered firm (VU) by the present value of the
interest tax shield; Tc x D. M&M Proposition I with taxes therefore states that:

VL = VU + TC x D

The effect of borrowing in this case is illustrated in figure 2.6. We have plotted the value of the
levered firm, VL, against the amount of debt, D. M&M relationship is given by a straight line with a
slope of TC and a y-intercept of VU. It is also drawn a horizontal line representing VU. As indicated,
the distance between the two lines is Tc x D, the present value of the tax shield.

Value of the Firm

VL = VU + TC x D

VL= 7300 TC x D

VU=7000 VU
VU

1000 Total Debt (D)

Figure 2.6

Suppose that the cost of the capital for the firm U is 10 percent (unlevered cost of capital, R U = 10%).
This is the cost of capital that the firm would have if it had no debt. Firm U’s cash flow is birr 700
every year forever. The value of the unlevered firm, VU, is:

VU = EBIT x (1-TC)
RU

VU = 1000 x (1-0.3)
0.10
= 7,000

The value of the levered firm, VL, is:

VL = VU + TC x D
= 7,000 + 0.3 x 1,000
= 7,300

As indicated in figure 2.6, the value of the firm goes up by birr 0.30 for every 1 birr in debt. It is
difficult to imagine why any corporation would not borrow to the absolute maximum under these
circumstances. The result of the analysis in this section is that, if tax is included, capital structure
definitely matters. However, we reach the illogical conclusion that the optimal capital structure
is 100 percent debt
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St. Mary’s University Department of Accounting
B. Taxes, the WACC, and Proposition II

The conclusion that the best capital structure is 100 percent debt also can be seen by examining the
weighted average cost of capital (WACC). If tax is considered, the WACC is computed as:

WACC = E/V X RE + D/V X RD X (1-TC)

Where V = D + E

To calculate WACC, we need to know the cost of equity. M&M Proposition II with corporate taxes
states that the cost of equity is:

RE = RU + (RU – RD) X (D/E) X (1-TC)

To illustrate, recall that firm L is worth birr 7,300 total (total asset of the firm). Since the debt is
worth birr 1,000, the equity must be worth 7,300-1,000 =6,300 birr. For firm L, the cost of equity is
thus: RE = RU + (RU – RD) X (D/E) X (1-TC)
= 10% + (0.1-0.08) x (1,000/6,300) x (1-0.30)
=10.22%
Therefore, the weighted average cost of capital is:
WACC = E/V X RE + D/V X RD X (1-TC)
= 6,300/7,300 x 10.22% + 1,000/7,300 x 8% x (1-0.3)
= 9.6%

With out debt, the WACC is 10 percent, and, with debt, it is 9.6 percent. Therefore, the firm is better
off with debt. As the WACC decrease the value of the firm increase.

The following figure summarizes the discussion concerning the relationship between the cost of
equity, the after tax cost of debt, and the weighted average cost of capital. For comparison, the cost of
capital for unlevered firm (RU) is included. In the figure 2.7 the horizontal axis is represented by
debt/equity ratio and notice that how the WACC declines as the debt/equity ratio rises.
This illustrates again that the more debt the firm uses, the lower is its WACC.
RE

RE = 10.22 %

RU = 10% RU

WACC = 9.6%
WACC
RD X (1-TC)
=8% X (1-0.3) RD X (1-TC)
=5.6%

1000/6,300 = D/E D/E ratio

Figure 2.7

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St. Mary’s University Department of Accounting
Example: You are given the following information for FAF Corporation:

EBIT = birr 151.52

Tc = 34%
D = birr 500
RU = 20%. The cost of debt capital is 10 percent. What is the value of FAF’s equity? What is the cost of
equity capital for FAF? What is the WACC?

Solution:
Remember that all the cash flows are perpetuities. The value of the firm if it had no debt, VU, is:
VU = EBIT x (1-TC)
RU
= 151.52 (1-0.34)
0.20
= birr 500

From M&M Proposition I with taxes, we know that the value of the firm with debt is:
VL = VU + TC x D
= 500 + 0.34 x 500
= birr 670

Since the firm is worth birr 670 total and the debt is worth birr 500, the equity is worth birr 170:
E = VL – D
= 670- 500 = 170

Thus, from M&M Proposition II with taxes, the cost of equity is:
RE = RU + (RU – RD) X (D/E) X (1-TC)
= 0.20 + (0.20-0.10) x (500/170) x (1-0.34)
= 39.4%

Finally, the WACC is:

WACC = E/V X RE + D/V X RD X (1-TC)
= (170/670) x 39.4% + (500/670) x 10% x (1-0.34)
= 14.92%

Notice that this is substantially lower than the cost of capital for the firm with no debt (RU = 20%), so
debt financing is highly advantageous.

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St. Mary’s University Department of Accounting
Modigliani and Miller Summary

I. The No tax case

A. Proposition I: The value of the firm levered (VL) is equal to the value of the firm
unlevered(VU):
VL=VU

Implication of Proposition I:
1. a firm’s capital structure is irrelevant
2. a firm’s weighted average cost of capital(WACC) is the same no matter what mixture of debt
and equity is used to finance the firm

B. Proposition II: The cost of equity, RE, is:

RE=RA+ (RA-RD)x D/E
Where RA is the WACC, RD is the cost of debt, and D/E is the debt/equity Ratio.
Implication of Proposition II:

1. the cost of equity rises as the firm increases its use of debt financing
2. the risk of the equity depends on two things: the riskiness of the firm’s operations ( business
risk) and the degree of financial leverage ( financial risk)

II. The tax case

A. Proposition I with taxes: The value of the firm levered (VL) is equal to the value of the
firm unlevered(VU) plus the present value of the interest tax shield:
VL= VU + Tc x D
Where Tc is the corporate tax rate and D is the amount of debt.

Implication of Proposition I:

1. Debt financing is highly advantageous, and, in the extreme, a firm’s optimal capital structure is
100 percent debt.
2. a firm’s weighted average cost of capital (WACC) decreases as the firm relies more heavily on
debt financing
B. Proposition II with taxes: the cost of equity, RE, is

RE= RU + (RU-RD) x D/E x (1-Tc)

Where, RU is the unlevered cost of capital, that is, the cost of capital for the firm if it had no
debt. Unlike Proposition I, the general implications

THE END
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