All-Equity Recession
EBIT
$1,000
Interest
0
Net income
$1,000
EPS
$2.50
ROA
5%
ROE
5%
Current Shares Outstanding = 400 shares
EBIT Interest Net income EPS ROA ROE
Levered Recession
Recession Expected Expansion
$1.50 $5.67
$9.83
Earnings for 24 shares Plus interest on $800 (8%) Net Profits ROE (Net Profits / $2,000)
$36 $64 $100 5%
$136 $64 $200 10%
SB
Value of the Firm
McGraw-Hill/Irwin
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
15-2
The Capital-Structure Question
There are really two important questions: 1. Why should the stockholders care about
McGraw-Hill/Irwin
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
15-9
Homemade Leverage: An Example
Recession Expected Expansion
Current Shares Outstanding = 400 shares
McGraw-Hill/Irwin
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
15-5
EPS and ROE Under Proposed Capital Structure
15-0
Chapter Outline
15.1 The Capital-Structure Question and The Pie Theory 15.2 Maximizing Firm Value versus Maximizing
Stockholder Interests 15.3 Financial Leverage and Firm Value: An Example 15.4 Modigliani and Miller: Proposition II (No Taxes) 15.5 Taxes 15.6 Summary and Conclusions
12.00
10.00
Debt
8.00
6.00
Break-even
point 4.00
No Debt
Advantage to debt
EPS
2.00
0.00 (2.00)
McGraw-Hill/Irwin
1,000
Disadvantage to debt
2,000
3,000
EBEIBTI in dollars, no taxes
McGraw-Hill/Irwin
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
15-1
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.
– Perfect competition – Firms and investors can borrow/lend at the same rate – Equal access to all relevant information – No transaction costs 15%
Buying 24 shares of an other-wise identical levered firm along with the some of the firm’s debt gets us to the ROE of the unlevered firm.
Proposed Shares Outstanding = 240 shares
McGraw-Hill/Irwin
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
15-7
Financial Leverage and EPS
• V=B+S
• If the goal of the management of the firm is to make the firm as valuable as possible, the the firm should pick the debt-equity ratio that makes the pie as big as possible.
Current Assets $20,000 Debt $0 Equity $20,000 Debt/Equity ratio 0.00 Interest rate n/a Shares outstanding 400 Share price $50
Proposed $20,000
$8,000 $12,000
15-3
Financial Leverage, EPS, and ROE
Consider an all-equity firm that is considering going into debt. (Maybe some of the original shareholders want to cash out.)
This is the fundamental insight of M&M
McGraw-Hill/Irwin
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
15-11
The MM Propositions I & II (No Taxes)
2/3 8% 240 $50
McGraw-Hill/Irwin
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
15-4
EPS and ROE Under Current Capital Structure
• Proposition I
– Firm value is not affected by leverage
• Proposition II
VL = VU
– Leverage increases the risk and 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
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
15-8
Assumptions of the Modigliani-Miller Model
• Homogeneous Expectations • Homogeneous Business Risk Classes • Perpetual Cash Flows • Perfect Capital Markets:
EBIT Interest Net income EPS ROA ROE
Recession $1,000 0 $1,000 $2.50 5% 5%
Expected $2,000 0 $2,000 $5.00 10% 10%
Expansion $3,000 0 $3,000 $7.50 15% 15%
EBIT Interest Net income EPS ROA ROE
Recession $1,000 640 $360 $1.50 5% 3%
Expected $2,000 640 $1,360 $5.67 10% 11%
Expansion $3,000 640 $2,360 $9.83 15% 20%
SL is the value of levered equity
McGraw-Hill/Irwin
As it turns out, changes in capital structure benefit the stockholders if and only if the value of the firm increases.
McGraw-Hill/Irwin
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.