Chapter 9: Optimal Capital Structure: M&M

I. Modigliani and Miller (1958): The NO-TAX Arbitrage Argument

M&M Proposition 1 (No taxes): Value of the Levered Firm = Value of the Unlevered Firm
M&M Proposition II: (No taxes): The WACC is the same for both

- M& M show that the EPS argument for leverage is misleading. They show that the corporation
should not try to increase EPS since the greater EPS also comes with greater risk.

- M&M argue that the correct action is to try to maximize firm value. Only changes that increase
the value of the firm are beneficial to shareholders.

- M&M show that changes in leverage alone does not affect value. If two firms have identical cash
flows, then their value must be the same, regardless of differences in leverage.

- Their famous arbitrage proof demonstrates that investors, by creating homemade leverage, will
cause two firms with identical cash flows to have identical values:

M&M Proposition 1 (No taxes): Firm value is indifferent to financial leverage

Firm Value Firm Value = Assets = Debt + Equity

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|_____________________________________________Value of the firm
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Debt/Assets

M&M Proposition 2 (No taxes): The WACC is indifferent to financial leverage

Cost of capital
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|______________________________________________WACC
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Fin 336: Chapter 9 - Optimal Capital Structure: M&M, p. 1

 Debt/Assets

M&M Proposition 2: Debt does not affect the WACC

- As the firm adds debt to its capital structure, the variability (risk) of EPS rises. Stockholders
demand a higher rate of return.

- The stockholders’ required rate will increase just enough to offset the benefit of adding low-cost
debt.

- The WACC will remain constant, so that value is constant.

Cost of capital
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kSL
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kSU |____________________________________WACC
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Debt/Assets

kSL = Required return for levered stock

kSU = Required return for unlevered stock
kSL = kSU + D/S (kSU – kD)

kSL = kSU + compensation for leverage risk.

Example:

D/S = 40/60 kSU = .10 kD = .075

= .10 + .40/.60 (.10 - .075)

= .1167 = Cost of equity for the levered firm

WACC = D/V(kD ) + S/V(kSL)

= .4(.075) + .6(.1167)

= .03 + .07

= .10 = Cost of equity for the unlevered firm

Fin 336: Chapter 9 - Optimal Capital Structure: M&M, p. 2

II. M&M with Taxes

Proposition 1 with Taxes:

When interest is tax deductible, there is a tax advantage to adding debt to the capital structure. Using
debt allows the government to subsidize the firm and increases the cash flows to the firm.

The advantage of tax deductibility of debt from taxable earnings is called the tax shield from debt.

Compare a firm with no debt to a firm with $4,000 of 5% debt:

Unlevered Firm Levered Firm

EBIT $ 1,000 $1,000
Interest 0 200
EBT 1,000 800
Taxes (.35) 350 280
Net Income $650 520

Total cash flow to stockholders and bondholders:

No Debt Firm: $650 Debt Firm: $520 + 200 = $720

The difference is $70

Tax shield from debt: TCkDD = .35(.05)($4,000) = $70

Assuming a similar savings every year into perpetuity, the present value of this tax shield is:

TCkDD/ kD = $70/.05 = $1,400

Adding debt will raise the value of the firm by $1,400!

Proposition I with Taxes:

Firm Value
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VL
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Debt/Assets
Cash Flows of the Levered Firm = Cash flows of the Unlevered Firm + Tax Shield

Unlevered Firm:

Fin 336: Chapter 9 - Optimal Capital Structure: M&M, p. 3

Taxable income: EBIT $1,000
Total Taxes (.35): EBIT x Tc $350
Earnings after Taxes: EBIT (1-Tc) $650

The total cash flow to the all-equity firm is $650 after taxes

Levered Firm:

Taxable income: EBIT – kDD = $1,000 - .05($4,000) = $800

Total Taxes: Tc(EBIT – kDD) = .35(1,000 – 200) = $280

Earnings to Stockholders:

EBIT – kDD - Tc(EBIT – kDD) = 1,000 – 200 - .35(1000-200) = $520

Earnings to Stock and Bond Holders

EBIT – kDD - Tc(EBIT – kDD)+ kDD

Cancel and Rearrange:

EBIT - Tc(EBIT – kDD) = EBIT(1 - Tc) + TckDD

= $650 + $70

= Unlevered cash flows plus tax-shield value

The total cash flow to the debt/equity firm is $720 after taxes

Bottom Line: The value of the debt tax-shield adds value to the firm

Firm Value
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VL
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VU |
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Debt/Assets

Proposition 2 with Taxes

kSL = kSU + D/S (1-Tc)(kSU – kD)

Fin 336: Chapter 9 - Optimal Capital Structure: M&M, p. 4

The WACC will fall as debt is added due to the effect of the tax shield on the costs of debt

Cost of capital
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kSL
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kSU |
| WACC
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Debt/Value

Limits to the Use of Debt: Costs of Financial Distress

Costs of Financial Distress offset the Tax Benefit of Debt:

- Financial distress includes all costs, including the direct costs of bankruptcy.

- Direct costs of financial distress are the legal and administrative charges that occur during
bankruptcy proceedings and that are taken from the cash flows that otherwise would go to the
bondholders and stockholders.

- Indirect costs of financial distress include:

* Impaired ability to conduct business

* Agency costs

- Incentives by managers to take on excessive risk

- Under-investment by existing stockholders
- Excessive dividend payout
- Excessive bond covenants

III. M&M with Taxes and Financial Distress: The Trade-off Theory

Fin 336: Chapter 9 - Optimal Capital Structure: M&M, p. 5

- Debt adds value up to a point

- After that point, the effects of financial distress offset entirely the tax benefits

- Setting the target capital structure that maximizes value is not a perfect science

- The capital structure that maximizes value will be the one that minimizes the WACC.

The Trade-Off Theory of Capital Structure refers to the idea that a company chooses
how much debt and how much equity to use by balancing the costs and benefits.

Fin 336: Chapter 9 - Optimal Capital Structure: M&M, p. 6

An important purpose of the theory is to explain the fact that corporations usually are
financed partly with debt and partly with equity. It states that there is an advantage to
financing with debt, the tax benefits of debt and there is a cost of financing with debt, the
costs of financial distress including bankruptcy costs of debt and non-bankruptcy costs
(e.g. staff leaving, suppliers demanding disadvantageous payment terms, bondholder and
stockholder infighting, etc). http://upload.wikimedia.org/wikipedia/commons/7/79/TradeOff.png
Following Modigliani and Miller's pioneering work on capital structure, we are left with
the question: "Is there such a thing as an optimal capital structure for a company? In other
words, is there a best way to finance the company: an optimal debt/equity ratio?"
According to the trade-off theory, the answer is yes - in fact, you might even say that
there is an optimal range. There is a specific debt/equity ratio that will minimize a
company's cost of capital. (This is also the point at which the value of the company will be
maximized.)
There is a danger of getting outside of this range however. The cost of capital will
increase rapidly once you get outside the range.
http://campus.murraystate.edu/academic/faculty/larry.guin/FIN330/Optimal%20Capital
%20Structure.htm

Conclusion: Capital Structure Theory

A. The Effect of Taxes

B. The Effect of Bankruptcy Costs

C. The Trade-Off Theory

D. Signaling Theory

E. Using Debt Financing to Constrain Managers

Appendix 1: M&M’s Arbitrage Proof for Proposition 1: Debt does not affect Firm Value

If two firms have identical cash flows, they should have identical value, regardless of differences in
leverage. M&M demonstrate that investors can arbitrage any profitable opportunities by substituting
homemade leverage for corporate leverage

Fin 336: Chapter 9 - Optimal Capital Structure: M&M, p. 7

If the stock of the levered firm is more highly valued than the stock of the unlevered firm, investors will
sell their shares in the levered firm, and purchase shares of the unlevered firm. They will substitute
homemade leverage by borrowing enough on a personal basis to replicate the risk they were exposed to
indirectly through the corporation. Since the risk level of the investor’s total investment is unchanged and
the expected cash flows are unchanged, then the total value of the investment should be the identical with
or without debt

Proof:
Two firms: Unlevered (U) and Levered (L) You own 100% of L
The cost of equity is 10 percent
The cost of debt is 7 ½ percent

Firm U has $900,000 in equity

Firm L has $400,000 in debt and $600,000 in equity
Expected operating cash flows (EBIT) is identical for both firms: $90,000.

Firm U Firm L
EBIT $90,000 $90,000
Interest $ 0 $30,000
NI $90,000 $60,000

Value U = 90,000/. 10 = $900,000

Value L = 60,000/. 10 + 30,000/. 075 = $1,000,000

Value of L’s stock = $600,000

Since Firm L has more value than Firm U, this violates M&M Proposition I since the operating cash flows
to the firms are identical. Your Arbitrage Action: Sell overvalued L shares and buy undervalued U shares

You get $600,000 for your shares. You also borrow an amount equal to L’s debt ($400,000). You buy all
of U’s stock for $900,000. (Leaving you with $100,000 extra cash!)

Old Net Income: $60,000

New Net Income: $90,000
Less interest due $30,000
Total new net income $60,000

Thus your net income hasn’t changed, but you have an additional $100,000 to play with!
Appendix 2: M&M Proposition 2 (No Taxes) Proof

S = Value of Common Stock D= Value of Debt D+S = A =Total Asset Value

RD = cost of debt RSU = Cost of unlevered equity RSL = Cost of levered equity

1. From Proposition 1, we know that the WACC for the levered firm must equal the
WACC for the unlevered firm (ie unlevered cost of equity), if their values are equal

Fin 336: Chapter 9 - Optimal Capital Structure: M&M, p. 8

 (which was proved in Proposition 1).

WACC = (D/D+S) x RD + (S/D+S) x RSL = RSU

WACC for levered and unlevered firms are equal (from Proposition 1)

2. Begin to use algebra:

RSL = {RSU - (D/D+S) x RD}/(S/D+S)

= {RSU x (D+S) – D x RD}/S

= {D x RSU + S x RSU – D x RD}/S

= RSU + {D x RSU – D x RD}/S

= RSU + {RSU – RD} x D/S Quod Erat Demonstrandum (Q.E.D.)

A detailed power point can be found at the following:

http://home.olemiss.edu/~lpkugele/WEB338/PPT_LPK/FIN338_Ch16_lpk.ppt

Explanation with Taxes can be found at the following:

Robert H. Smith School of Business

Fin 336: Chapter 9 - Optimal Capital Structure: M&M, p. 9