FINM 7402 MM Theory of Capital Structure
MM Theory of Capital Structure
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FINM 7402 Corporate Finance (Advanced)
MM Theory of Capital Structure
Week 2
Reading: Chapter 14
CRICOS code 00025B
• CAPM:
• Regress asset excess return (Ri – Rf) on market excess return (Rm- Rf).
• Estimate a company’s cost of equity using the CAPM equation
• Estimate the cost of debt, given a company’s yield to maturity (y), probability
of default (p), and expected loss rate (L).
rd = (1 - p)y + p(y - L) = y - pL
= Yield to Maturity – Prob(default) * Expected Loss Rate
• Estimate a company’s cost of debt using the CAPM equation
Recall Week1 …
2
ri=rf +βi × (E[RMkt ]-rf )
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( ) ( ) i f i i Mkt f iR r R r− = + − +α β ε
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• Cost of equity capital: , β = + β∗ E −
• Cost of debt capital: , β
= + β∗ E −
• Asset cost of capital: , β
Firm beta as weighted average: the beta of a firm is the weighted average of the betas of its
individual components
β: unlevered beta , asset beta, also commonly denoted as β
β: levered beta, equity beta , also commonly denoted as β
Recall Week1 …
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DEA ED
D
ED
E βββ
+
+
+
=
DEA rED
Dr
ED
Er
+
+
+
=
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Practice
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Solution
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• The value of a firm is defined to be the sum of the value of the firm’s debt and the
firm’s equity: V = D + E
• Based on expected business cash flows, the value of the firm is
= �
=1
(1+)
Capital Structure and the Pie
If the goal of the firm’s management is to
make the firm as valuable as possible,
then the firm should pick the debt-equity
ratio that makes the pie as big as
possible.
Value of the Firm
S DE
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DEA rED
Dr
ED
Er
+
+
+
=
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• Definition
How a business (firm) finances its overall operations and growth by using
different sources of funds, eg, debt, equity, etc.
• Optimal capital structure [the big question!]
The capital structure which maximizes the value of a company.
• Does the value of the cash flows depend on how it is divided between
payments to lenders and shareholders?
Background on Capital Structure
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• a perfect market with no taxes
• a slightly less perfect market with taxes
• a world in which the costs of financial distress matter
• a world with other transactions costs
• a world with conflicts of interest between managers and shareholders, or
debtholders and shareholders
The answer depends on the ‘world’ we are in
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A perfect market with no taxes or any of the other imperfections listed in
previous slide.
Assumptions:
• Homogeneous Expectations
• Perpetual Cash Flows
• Perfect Capital Markets:
o Perfect competition
o Firms and investors can borrow/lend at the same rate
o Equal access to all relevant information
o No transaction costs
o No taxes
Modigliani & Miller Analysis (MM)
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• The market value of any firm is independent of its capital structure.
If a company has a given set of assets, changing debt to equity will change the way
net operating income is divided between lenders and shareholders but will not
change the value of the company.
VL = VU = E + D
Financial decisions are irrelevant for firm value. In particular, the choice of
capital structure is irrelevant.
Proof:
All purely financial transactions are zero NPV investments, i.e., no arbitrage
opportunity. Thus, they neither increase nor decrease firm value.
MM’s Proposition I
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• MM theory is established based on the Law of One Price: in a perfect capital market, the
firm’s choice of capital structure does not change the cash flows generated by its assets,
hence, the capital structure decision will no change the value of the firm.
• Two firms producing the same cash flows must have the same value --- No arbitrage
• If not, it is an “arbitrage opportunity”: possible to generate a riskless profit that requires no
initial investment:
- buy the one with the low price,
- sell the one with the high price,
- keep the difference in prices,
- future cash flows will cancel out
• Competition among investors should drive any arbitrage opportunities out of the market
Proof by Arbitrage
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• Two firms, U and L.
• Firm U is unlevered and Firm L is levered.
• Firm L has borrowed $4,000,000 at 7.5%.
• Both firms make a profit of $900,000 --- producing same cash flows.
• Required equity return is 10% [insensitive to risk, violate MM].
Arbitrage Example
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Firm U (Unlevered):
• Value of equity =
• Value of firm =
Arbitrage Example
=
$900,000 $9,000,000
0.10
+ = + =$9M 0 $9MD E
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Firm L (Leveraged):
value of firm =
Leverage create value ?!
Arbitrage Example
−
=
=
$900,000 $300,000value of equity
0.1
$6,000,000
= ×
=
interest expense 0.075 $4,000,000
$300,000
+ = + =$6M $4M $10MD E
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• Arbitrager: sells 10% of Firm L and buys Firm U with the cash raised
• Firm L: VL = $10M, 60% Equity + 40%Debt
• 10% Firm L = $1M, 60% Equity ($0.6m) + 40%Debt ($0.4M)
In other words, the arbitrager raised $1M cash by selling $0.6M equity of firm L
and borrowing $0.4M of debt (with debt interest 7.5%).
The Arbitrage Process
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• Work out the return if all of these funds are invested in the Firm U:
• This is a gross return and does not factor in costs.
= ×
=
1,000,000Return $900,000
9,000,000
$100,000
The Arbitrage Process
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• Work out the net return:
• Return from unlevered firm $100,000
• less Interest on borrowings $ 30,000 ( 7.5%*400,000)
• less cost to L equity holders $ 60,000 ( 10%*600,000)
• Net return $ 10,000 p.a.
• This represents a riskless income of $10,000 per year.
The Arbitrage Process
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• As the arbitraging process goes, selling L to buy U, it eventually pushes
down the value of firm L and push up the value of firm U, until VL = VU
• Equity return on firm L increases to beyond 10% , and equity return on firm U
will be lower than 10%. Leverage increase equity risk and hence equity
return.
The Arbitrage Process
What does this imply for the equity return on levered
firms vs. unlevered firms?
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MM Proposition I
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Debt-to-equity Ratio
C
os
t o
f c
ap
ita
l:
R
(%
)
RU
E
D
• Recall that the value of the firm is
= �
=1
(1+)
• In a perfect market without taxes and other
frictions, a firm’s cash flows (CFs) only
divided between equity and debt holders.
Leverage won’t change the total amount of
CFs.
• The implication of MM Proposition I is that
or does not change with capital structure
choice in a perfect market.
= + + +
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Leverage increases the risk and return to stockholders
RD is the interest rate (cost of debt)
RE is the return on equity (cost of equity)
RU is the return on asset (can also be denoted as RA) / unlevered equity (cost of
capital)
D is the market value of debt
E is the market value of equity
MM Proposition II
( )DUUE RRE
DRR −×+=
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The derivation is straightforward:
MM Proposition II
21
UED RRED
ER
ED
D
=×
+
+×
+ E
ED +by sidesboth multiply
UED RE
EDR
ED
E
E
EDR
ED
D
E
ED +
=×
+
×
+
+×
+
×
+
UED RE
EDRR
E
D +
=+×
UUED RRE
DRR
E
D
+=+× )( DUUE RRE
DRR −+=
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MM Proposition II
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Debt-to-equity
Ratio
C
os
t o
f c
ap
ita
l:
R
(%
)
RU
RD
)( DUUE RRE
DRR −×+=
RD
E
D
= + + +
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• Changing proportion of equity vs debt change equity beta ( ) or levered beta ( )
• But asset beta ( ) or unlevered beta ( ) stays the same
• Hence equity premium increase as leverage increases. But required asset return
(determined by asset beta) does not change, so is the value of the firm.
• Purely financial transactions in a perfect capital market are zero NPV projects. Thus, they
neither increase nor decrease firm value.
From beta perspective …
DEA ED
D
ED
E βββ
+
+
+
=
= + −
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(1)
(2)
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• Because (for essentially all firms) debt is safer than equity, investors demand
a lower return for holding debt than for holding equity. (True)
• So a firm can reduce its cost of capital by increasing leverage.
• What is wrong with this argument?
WACC Fallacy: “Debt is Better Because Debt Is
Cheaper Than Equity”
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= = + + +
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• This reasoning ignores the “hidden” cost of debt:
Raising more debt makes existing equity more risky
• Note: Unrelated to default risk, i.e., true even if debt is risk-free.
WACC Fallacy
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• EPS can go up (or down) when a company increases its leverage. (True)
• Companies should choose their financial policy to maximize their EPS.
(False)
• What is wrong with this argument?
EPS Fallacy: “Debt is Better When It Makes EPS Go Up.”
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• 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.
• Assume that LVI’s EBIT stays the same in the future and that all earnings are
paid as dividends. Are shareholders better off with the increased leverage?
EPS Fallacy: Example
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• Suppose LVI has no debt. Since there is no interest and no taxes, LVI’s
earnings would equal its EBIT and LVI’s earnings per share without leverage
would be:
EPS Fallacy: Example
Earnings $10 million $1
Number of Shares 10 million
EPS = = =
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• If LVI recapitalizes, the new debt will obligate LVI to make interest payments
each year of $1.2 million.
• $15 million × 8% = $1.2 million
• As a result, LVI will have expected earnings after interest of $8.8 million.
• Earnings = EBIT – Interest
• Earnings = $10 million – $1.2 million = $8.8 million
EPS Fallacy: Example
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• LVI’s Earnings per Share (EPS) rises to $1.10
• $8.8 million ÷ $8 million shares = $1.10
• LVI’s expected earnings per share increases with leverage.
• But, are shareholders better off?
• Shareholders would be better off if the increased EPS for LVI can lead to an
increase in the share price.
EPS Fallacy: Example
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• Although LVI’s expected EPS rises with leverage, the risk of its EPS also
increases.
• 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.
EPS Fallacy: Example
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Illustrate without formula…
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• Unlevered LVI : V = 75m, expected EBIT = 10m, all goes to equity holders
• Levered LVI: V (75m) = E (60m) + D (15m), expected EBIT = 10m, 8.8m
goes to equity holders, and 1.2m goes to debt holders
• Suppose two state economy: good state (G) with 50% chance and bad state
(B) with 50% chance.
• Expected equity return for unlevered LVI: 0.5*20% + 0.5*6.67% = 13.33%
• Expected equity return for levered LVI: 0.5*23% + 0.5*6.3% = 14.66%
15m (G), Re = 15/75=20%
5m (B), Re = 5/75=6.67%
Unlevered LVI
13.8m (G), Re = 13.8/60=23%
3.8m (B), Re = 3.8/60=6.33%
Levered LVI
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• Dilution
• An increase in the total of shares that will divide a fixed amount of earnings
• It is sometimes (incorrectly) argued that issuing equity will dilute existing
shareholders’ ownership, so debt financing should be used instead.
• With new shares issued, the cash flows generated by the firm must divided
among a larger number of shares, thereby reducing the value of each share.
Capital Structure Fallacy: Equity Issuances and Dilution
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• Suppose Jet Sky Airlines (JSA) currently has no debt and 500 million shares
of stock outstanding, currently trading at a price of $16.
• Last month the firm announced that it would expand and the expansion will
require the purchase of $1 billion of new planes, which will be financed by
issuing new equity.
• How will the share price change?
• The current (prior to the issue) value of the equity and the assets of the firm
is $8 billion.
• 500 million shares × $16 per share = $8 billion
Equity Issuances and Dilution
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• Suppose JSA sells 62.5 million new shares at the current price of $16 per
share to raise the additional $1 billion needed to purchase the planes.
Equity Issuances and Dilution
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• Results:
• The market value of JSA’s assets grows because of the additional $1 billion
in cash the firm has raised.
• The number of shares increases.
o Although the number of shares has grown to 562.5 million, the value per
share is unchanged at $16 per share.
Equity Issuances and Dilution
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• As long as the firm sells the new shares of equity at a fair price, there will be
no gain or loss to shareholders associated with the equity issue itself.
• Any gain or loss associated with the transaction will result from the NPV of
the investments the firm makes with the funds raised
Equity Issuances and Dilution
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• How does financial leverage affect firm value without taxes?
• If a change in leverage raises a firm’s EPS, should this cause its share price
to rise in a perfect capital market?
• True/False: When a firm issues equity, it increases the supply of its shares in
the market, which should cause its share price to fall.
Quick Quiz
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• M-M marks the beginning of the modern theory of corporate finance. Before
that, corporate finance was viewed as part of accounting.
• M-M is not a literal statement about the real world. It obviously leaves
important things out.
• But it gets you to ask the right question: How is this financing move going to
change the size of the pie?