Capital Structure. MODIGLIANI AND MILLER. ANY COMBINATION OF SECURITIES IS AS GOOD AS ANY OTHER EXAMPLE: TWO FIRMS, SAME OPERATING INCOME DIFFER ONLY IN CAPITAL STRUCTURE FIRM U UNLEVERED, V U = E U FIRM L IS LEVERED, E L = V L - D L. MODIGLIANI AND MILLER. TWO STRATEGIES
FROM OWNING 01DL .01 INTEREST
FROM OWNING .01EL .01 (PROFITS - INTEREST)
TOTAL .01 PROFITS
FROM BORROWING 01DL -.01 INTEREST
FROM OWNING .01EL .01 (PROFITS
TOTAL .01 (PROFITS-INTEREST)
.01(VL - DL) = .01(VU - DL) AND VU = VL
rA = EXPECTED OPERATING INCOME
MARKET VALUE OF ALL SECURITIES
rA = (D/D+E)rD + (E/D+E)rE
rE = rA + (D/E)(rA - rD) MM PROPOSITION 2
EXPECTED RETURN ON EQUITY
= EXPECTED RETURN ON ASSETS
+ DEBT - EQUITY RATIO x (EXPECTED RETURN ON ASSETS
-EXPECTED RETURN ON DEBT)
AS LEVERAGE INCREASES, VA AND rA ARE UNCHANGED
BUT THE EXPECTED RETURN ON EQUITY INCREASES
FOR RISKY DEBT, rD INCREASES AS LEVERAGE INCREASES
Debt-equity ratio (D/E)
WE KNOW THAT
A= (D/D + E)D + (E/D + E)E
E = A + (D/E)(A - D )
PV (TAX SHIELD)
= TAX RATE x INTEREST PAYMENT / DISCOUNT RATE
= TC (rDD) /rD
PV (TAX SHIELD = TC (rDD)(1-TP) / rD(1-TP)
WHICH WAS OUR ORIGINAL FORMULA
= VALUE IF ALL-EQUITY-FINANCED + PV(TAX SHIELD)
VALUE OF FIRM = VALUE IF ALL-EQUITY-FINANCED +TCD
VALUE OF FIRM
= VALUE IF ALL EQUITY-FINANCED
+ PV(TAX SHIELD)
- PV(COSTS OF FINANCIAL DISTRESS)
PV Tax Shield
PV Costs Of Distress
Value of levered firm
Value If All
Trade-off Theory - Theory that capital structure is based on a trade-off between tax savings and distress costs of debt.
Pecking Order Theory - Theory stating that firms prefer to issue debt rather than equity if internal finance is insufficient.
1. Stock-for-debt Stock price
exchange offers falls
Debt-for-stock Stock price
exchange offers rises
2. Issuing common stock drives down stock prices; repurchase increases stock prices.
3. Issuing straight debt has a small negative impact.
Consider the following story:
The announcement of a stock issue drives down the stock price because investors believe managers are more likely to issue when shares are overpriced.
Therefore firms prefer internal finance since funds can be raised without sending adverse signals.
If external finance is required, firms issue debt first and equity as a last resort.
The most profitable firms borrow less not because they have lower target debt ratios but because they don't need external finance.