Capital Structure 10
Capital Structure 10
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MAXIMIZING FIRM VALUE VERSUS MAXIMIZING
STOCKHOLDER INTERESTS
EXAMPLE
Suppose the market value of the J.J. Sprint company is $1,000. The
company currently has no debt, and each of J.J. Sprint’s 100 shares of
stock sells for $10. A company such as J. J. Sprint with no debt is called
an unlevered company. Further suppose that J. J. Sprint plan to borrow
$500 proceed to shareholder as an extra cash dividend of $5 per share.
After the issuance of debt, the firm becomes levered. The investments of
the firm will not change as result of this transaction. What will the value
of the firm be after the proposed restructuring?
Management recognizes that, by definition, only one of three out comes
can occur restructuring. Firm value after restructuring can be either (1)
greater than the original firm value of $1,000, (2) equal to $1,000, or (3)
less than $1,000.
After consulting with investment bankers, management believes that
restructuring will not change firm value more than $250 in either
direction. Thus, they view firm values of $1,250, and $ 1,000, and $750
as the relevant range. The original capital structure and these possibilities
under the new capital structure and these three possibilities under the
new capital structure are presented next.
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No Debt Value of Debt plus Equity after
(original Payment of Dividend (three
capital possibilities)
structure)
I II III
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# FINANCIAL LEVERAGE AND FIRM VALUE: AN EXAMPLE
Trans Am Corporation currently has no debt in its capital structure. The firm is
considering issuing debt to buy back some of its equity. Both its current and
proposed capital structures are presented in Table 15.1. The firm’s assets are
$8,000. There are 400 shares of the all-equity firm,implying a market value per
share of $20. The proposed debt issue is for $4,000, leaving $4,000 in equity. The
interest rate is 10 percent.
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Figure 15.2 Financial Leverage: EPS and EBI
for the Trans Am Corporation
Earning per
share (EPS) in
dollars
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4 Debt No debt
3 Advantage
to debt
2 Break-even point
1 Disadvantage
to debt
Earning before
0 interest (EBI)
$400 $800 $1,200 $1,600 $2,000
in dollars, no taxes
-1
-2
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Table 15.2 Trans Am’s Current Capital Structure: No Debt
Recession Expected Expansion
Return on assets (ROA) 5% 15% 25%
Earnings $400 $1,200 $2,000
Return on Equity (ROE) = Earnings/Equity 5% 15% 25%
Earnings per share (EPS) $1.00 $3.00 $5.00
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The Choice Between Debt and Equity
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Table 15.4 Payoff and Cost to Shareholders of Trans Am Corporation under the Proposed
Structure and under the Current Structure with Homemade Leverage
EPS A: Buy 100 Shares of Levered Equity Recession Expected Expansion
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MODIGLIANI AND MILLER: PROPOSITION II (NO TAXES)
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Lets us now define ro to be the cost of capital for an all-equity
firm. For the Trans Am Corp., ro is calculated as:
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Table 15.5 Cost of Capital Calculations for Trans Am
B S
rWACC rB rS
BS BS
0 $8,000
Unlevered firm: 15% 10% * 15% * *
$8,000 $8,000
$4,000 $4,000
Levered firm: 15% 10% * 20% * * *
$8,000 $8,000
*10% is the interest rate.
** From “Expected” column in Table 15.2, we learn that expected earning after interest for the unlevered firm are
$1,200. From table 15.1, we learn that equity for the unlevered firm is $8,000. Thus, rs for the unlevered firm is:
Proposition II states the expected return of equity, rs, in terms of leverage. The exact relationship, derived by
setting formula (15.2), is
MM Proposition II (no taxes)
B
rs ro (ro rb )
S 11
Example illustrating proposition I and Proposition II
Example:
Luteran Motors, an all-equity firm, has expected earnings of
$10 million per year in perpetuity. The firm pays all of its
earnings out as dividens, so that the $10 million may also be
viewed as the stockholders’ expected cash flow. There are 10
million shares outstanding, implying expected annual cash flow
of $1 per share. The cost of capital for this unlevered firm is
10 percent. In addition, the firm will soon build a new plant for
$4 million. The plant is expected to generate additional cash
flow of $ 1 million per year. These figures can be described as
$10 million
Old assets : $100 million Equty: $100 million
0 .1
(10 million shares of stock)
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LUTERAN MOTOR
Balance Sheet
(upon announcement of equity issue to construct plant
Old assets $100 million Equity $106 million
NPV of plant: (10 million shares of stock)
$1 million 6 million
4 million
0 .1
Total assets $106 million
LUTERAN MOTOR
Balance Sheet
(upon announcement of equity issue to construct plant
Old assets $100 million Equity $106
NPV of plant: million
$1 million 6 million (10 million shares of
4 million
0 .1 stock)
Total assets $106 million
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The Quirk in the Tax Code
Example
The Water Products Company has a corporate tax rate, TC, of
35 percent and expected earnings before interest and taxes
(EBIT) of $1 million each year, its entire earnings after taxes
are paid out of dividends.
The firm is considering two alternative capital structures.
Under plan I, Water Products would have no debt in its capital
structure. Under plan II, the company would have $4,000,000
of debt,B. The cost of debt, rb, is 10 percent.
The chief financial officer for Water Products makes the following
calculation:
Plan I Plan II
Earning before interest and corporation taxes (EBIT) $1,000,000 $1,000,000
Interest (rbB) 0 (400,000)
VL
570
VU = 500
Debt (B)
0 200
VL = VU + TCB
= $500 + (0.35 X $200)
= $570
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The Weighted Average Cost of Capital rWACC and Corporate Taxes
200 370
rWACC 0.10 0.65 0.2351
570 570
0.1754
Devided Airlines has reduced its rWACC from 0.20 (with no debt) to 0.1754
with reliance on debt. This result is intuitively pleasing because it suggest,
when a firm lowers its rWACC, the firm’s value will increase. Using the rWACC
approach, we can confirm that the value of Divided Airlines is $570
EBIT (1 TC ) $100
VL
rWACC 0.1754
$570
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