Ch 14 Capital Structure in Perfect Markets II

MMII: Leverage, Risk, and the Cost of Capital

Leverage and The Equity Cost of Capital
We can use Modigliani and Miller’s first proposition to derive an explicit
relationship between leverage and the equity cost of capital. 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. Then MM Proposition I states that
That is, the total market value of the firm’s
securities is equal to the market value of its assets,
whether the firm is unlevered or levered.
We can interpret the first equality in Eq. 14.2 in terms of homemade leverage: By
holding a portfolio of the firm’s equity and debt, we can replicate the cash flows
from holding unlevered equity. Because the return of a portfolio is equal to the
weighted average of the returns of the securities in it, this equality implies the
following relationship between the returns of levered equity RE, debt RD, and
unlevered equity RU:
If we re-arrange 14.3 for R(E) we get
14.4

The levered equity return equals the unlevered return, plus an extra “kick” due
to leverage. This extra effect pushes the returns of levered equity even higher
when the firm performs well RU>RD, but makes them drop even lower when the
firm does poorly RU<RD. The amount of additional risk depends on the amount
of leverage, measured by the firm’s market value debt-equity ratio, D/E. Because
Eq. 14.4 holds for the realized returns, it holds for the expected returns as well
(denoted by r in place of R).
MM Proposition II: The cost of capital of levered equity increases with the firms
market value debt-equity ratio.
Recall that if the firm is all-equity financed, the
expected return on unlevered equity is 15%
(see Table 14.4). If the firm is financed with
$500 of debt, the expected return of the debt is
the risk-free interest rate of 5%. Therefore, according to MM Proposition II, the
expected return on equity for the levered firm is:
Eg 14.4 Computing the Equity Cost of Capital

Capital Budgeting and the weighted Average Cost of Capital

If a firm is financed with both equity and debt, then the risk of its underlying
assets will match the risk of a portfolio of its equity and debt. Thus, the
appropriate cost of capital for the firm’s assets is the cost of capital of this
portfolio, which is simply the weighted average of the firm’s equity and debt cost
of capital:

Because we are in a setting of perfect capital markets, there are no taxes, so the
firm’s WACC and unlevered cost of capital coincide:

That is with perfect capital markets, a firms WACC is independent of its capital
structure and is equal to its equity cost of capital if it is unlevered, which
matches the cost of capital of its assets. No matter the debt to equity ratio of a
firm the WACC remains unchanged.
Thus, Eq. 14.7 provides the following intuitive interpretation of MM Proposition I:
Although debt has a lower cost of capital than equity, leverage does not lower a
firm’s WACC. As a result, the value of the firm’s free cash flow evaluated using
the WACC does not change, and so the enterprise value of the firm does not
depend on its financing choices.
With perfect capital markets, the firm’s weighted average cost of capital, and
therefore the NPV of the expansion, is unaffected by how EBS chooses to finance
the new investment.
Eg 14.5 Reducing Leverage and the Cost of Capital

Eg 14.6 WACC with Multiple Securities

Levered and Unlevered Betas
A firm’s unlevered or asset beta is the weighted average of its equity and debt
beta:

When a firm changes its capital structure without changing its investments, its
unlevered beta will remain unaltered. However, its equity beta will change to
reflect the effect of the capital structure change on its risk. 4
Equation 14.9 is analogous to Eq. 14.5, with beta
replacing the expected returns. It shows that the
firm’s equity beta also increases with leverage.
Eg 14.7 Betas and Leverage
Eg 14.8 Cash and the Cost of Capital

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.

Leverage and EPS

Leverage can increase a firm’s expected EPS. An argument sometimes made is
that by doing so, leverage should increase the firms stock price.
Consider the following example. Levitron Industries (LVI) is currently an all-equity
firm. It expects to generate earnings before interest and taxes (EBIT) of $10
million over the next year. Currently, LVI has 10 million shares outstanding, and
its stock is trading for a price of $7.50 per share. LVI is considering changing its
capital structure by borrowing $15 million at an interest rate of 8% and using the
proceeds to repurchase 2 million shares at $7.50 per share.
Suppose LVI has no debt. Because LVI pays no interest, and because in perfect
capital markets there are no taxes, LVI’s earnings would equal its EBIT. Therefore,
without debt, LVI would expect earnings per share of
As we can see, LVI’s expected earnings per share increases with leverage. 5 This
increase might appear to make shareholders better off and could potentially lead
to an increase in the stock price. Yet we know from MM Proposition I that as long
as the securities are fairly priced, these financial transactions have an NPV of
zero and offer no benefit to shareholders. How can we reconcile these seemingly
contradictory results?
5
More generally, leverage will increase expected EPS whenever the firm’s after-
tax borrowing cost is less than the ratio of expected earnings to the share price
(i.e., the reciprocal of its forward P/E multiple, also called the earnings yield). For
LVI, with no taxes, 8%<EPS/P=1/7.50=13.33%.
The answer is that the risk of earnings has changed. Thus far, we have
considered only expected earnings per share. We have not considered the
consequences of this transaction on the risk of the earnings. To do so, we must
determine the effect of the increase in leverage on earnings per share in a
variety of scenarios.
Suppose earnings before interest payments are only $4 million. Without the
increase in leverage, EPS would be $4 million÷10 million shares=$0.40. With the
new debt, however, earnings after interest payments would be $4 million−
$1.2 million=$2.8 million, leading to earnings per share of
$2.8 million÷8 million shares=$0.35. So, when earnings are low, leverage will
cause EPS to fall even further than it otherwise would have. Figure 14.2 presents
a range of scenarios.
if earnings before interest exceed $6 million, then EPS is higher with leverage.
When earnings fall below $6 million, however, EPS is lower with leverage than
without it. So, although LVI’s expected EPS rises with leverage, the risk of its EPS
also increases. The increased risk can be seen because the line showing EPS with
leverage in Figure 14.2 is steeper than the line without leverage, implying that
the same fluctuation in EBIT will lead to greater fluctuations in EPS once leverage
is introduced. While EPS increases on average, this increase is necessary
to compensate shareholders for the additional risk they are taking, so
LVI’s share price does not increase as a result of the transaction.

Eg 14.9 The MM proposition and EPS

Conservation of value principle for financial markets
The conservation of value principle for financial markets states that with perfect
capital markets, financial transactions neither add nor destroy value, but instead
represent a repackaging of risk and return.