Chapter 14

Capital Structure
in a Perfect Market

Copyright © 2011 Pearson Prentice Hall. All rights reserved.

What is the capital structure question?

What considerations should guide firms when making

financing decisions?
Example (from text):
Dan Harris, CFO of EBS, is reviewing plans for a major
expansion. To pursue the expansion, EBS plans to raise
$50 million from outside investors. One possibility is to
raise the funds by selling shares of EBS stock. Due to
the firm’s risk, Dan estimates that equity investors will
require a 10% risk premium over the 5% risk-free interest
rate. That is, the company’s equity cost of capital is 15%.

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What is the capital structure question?

Example (continued):
Some senior executives at EBS, however, have argued that
the firm should consider borrowing the $50 million
instead. EBS has not borrowed previously and, given its
strong balance sheet, it should be able to borrow at 6%
interest rate. Does the low interest rate of debt make
borrowing a better choice of financing for EBS? If EBS
does borrow, will this choice affect the NPV of the
expansion, and therefore change the value of the firm
and its share price?

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Financing a Firm with Equity
• You are considering an investment opportunity.
For an initial investment of $800 this year, the project will
generate cash flows of either $1400 or $900 next year,
depending on whether the economy is strong or weak,
respectively. Both scenarios are equally likely. The
project cash flows depend on the overall economy and
thus contain market risk. As a result, you demand a
10% risk premium over the current risk-free interest
rate of 5% to invest in this project.
a) What is the NPV of this investment opportunity?
b) If you finance this project using only equity, how much
would you receive for the project?
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Financing a Firm with Equity (cont'd)

• Unlevered Equity
 Equity in a firm with no debt

• Because there is no debt, the cash flows of the

unlevered equity are equal to those of the project.

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Financing a Firm with Debt and Equity

• Suppose you decide to borrow $500 initially, in

addition to selling equity.
 Because the project’s cash flow will always be enough
to repay the debt, the debt is risk free and you can
borrow at the risk-free interest rate of 5%. You will owe
the debt holders:
• $500 × 1.05 = $525 in one year.

• Levered Equity
 Equity in a firm that also has debt outstanding

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The capital structure question: Is E><500?

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Financing a Firm
with Debt and Equity (cont'd)

• Modigliani and Miller argued that with perfect

capital markets, the total value of a firm should
not depend on its capital structure.
• Because the cash flows of the debt and equity sum to the
cash flows of the project, by the Law of One Price the
combined values of debt and equity must be $1000.
 Therefore, if the value of the debt is $500, the value of
the levered equity must be $500.
• E = $1000 – $500 = $500.

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The Effect of Leverage on Risk and Return

• Leverage increases the risk of the equity of a firm.

 Therefore, it is inappropriate to discount the cash flows
of levered equity at the same discount rate of 15% that
you used for unlevered equity. Investors in levered
equity will require a higher expected return to
compensate for the increased risk.

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Table 14.4

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Table 14.5

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The Effect of Leverage
on Risk and Return (cont'd)

• In summary:
 Leverage increases the risk of equity even when there
is no risk that the firm will default.
• Thus, while debt may be cheaper, its use raises the cost of
capital for equity. Considering both sources of capital
together, the firm’s average cost of capital with leverage is
the same as for the unlevered firm.

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Chapter 14: problem 1

Consider a project with free cash flows in one year of $130,000 or

$180,000, with each outcome being equally likely. The initial
investment required for the project is $100,000, and the project’s
cost of capital is 20%. The risk-free interest rate is 10%.
a. What is the NPV of this project?
b. Suppose that to raise the funds for the initial investment, the
project is sold to investors as an all-equity firm. The equity
holders will receive the cash flows of the project in on year. How
much money can be raised in this way – that is, what is the initial
market value of the unlevered equity?
c. Suppose the initial $100,000 is instead raised by borrowing at the
risk-free interest rate. What are the cash flows of the levered
equity, and what is its initial value according to MM?

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14.2 Modigliani-Miller I: Leverage,
Arbitrage, and Firm Value (cont'd)

• Modigliani and Miller (MM) showed that this result

holds more generally under a set of conditions
referred to as perfect capital markets:
 Investors and firms can trade the same set of securities
at competitive market prices equal to the present value
of their future cash flows.
 There are no taxes, transaction costs, or issuance
costs associated with security trading.
 A firm’s financing decisions do not change the cash
flows generated by its investments, nor do they reveal
new information about them.

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14.2 Modigliani-Miller I: Leverage,
Arbitrage, and Firm Value (cont'd)

• MM Proposition I:
 In a perfect capital market, the total value of a firm is
equal to the market value of the total cash flows
generated by its assets and is not affected by its choice
of capital structure.

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Homemade Leverage

• Homemade Leverage
 When investors use leverage in their own portfolios to
adjust the leverage choice made by the firm.

• MM demonstrated that if investors would prefer an

alternative capital structure to the one the firm has
chosen, investors can borrow or lend on their own
and achieve the same result.

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Homemade Leverage (cont'd)
• Assume you use no leverage and create an all-
equity firm.
 An investor who would prefer to hold levered equity can
do so by using leverage in his own portfolio.

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 Homemade Leverage (cont'd)
• Now assume you use debt, but the investor would prefer
to hold unlevered equity. The investor can re-create the
payoffs of unlevered equity by buying both the debt and
the equity of the firm. Combining the cash flows of the two
securities produces cash flows identical to unlevered
equity, for a total cost of $1000.

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Homemade Leverage (cont'd)

• In each case, your choice of capital structure does

not affect the opportunities available to investors.
 Investors can alter the leverage choice of the firm to
suit their personal tastes either by adding more
leverage or by reducing leverage.
 With perfect capital markets, different choices of capital
structure offer no benefit to investors and does not
affect the value of the firm.

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Chapter 14: problem 6

Suppose Alpha Industries and Omega Technology have

identical assets that generate identical cash flows. Alpha
Industries is an all-equity firm, with 10 million shares
outstanding that trade for a price of $22 per share. Omega
Technology has 20 million shares outstanding as well as
debt of $60 million.
a. According to MM proposition 1, what is the stock price for
Omega Technology?
b. Suppose Omega Technology stock currently trades for
$11. What arbitrage opportunity is available if you decide
to buy (or maybe sell) 20 shares of omega? What
assumptions are necessary to exploit this opportunity?
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The Market Value Balance Sheet

• Market Value Balance Sheet

 A balance sheet where:
• All assets and liabilities of the firm are included (even
intangible assets such as reputation, brand name, or
human capital that are missing from a standard accounting
balance sheet).
• All values are current market values rather than
historical costs.

 The total value of all securities issued by the firm must

equal the total value of the firm’s assets.

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Table 14.8

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The Market Value Balance Sheet (cont'd)

• Using the market value balance sheet, the value

of equity is computed as:
Market Value of Equity 
Market Value of Assets  Market Value of Debt and Other Liabilities

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Example 14.3

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 Application: A Leveraged Recapitalization
• Leveraged Recapitalization
 When a firm uses borrowed funds to pay a large
special dividend or repurchase a significant amount
of outstanding shares

• Example:
 Harrison Industries is currently an all-equity firm
operating in a perfect capital market, with 50 million
shares outstanding that are trading for $4 per share.
 Harrison plans to increase its leverage by borrowing
$80 million and using the funds to repurchase 20 million
of its outstanding shares.
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Table 14.9

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14.3 Modigliani-Miller II: Leverage, Risk,
and the Cost of Capital
• Leverage and the Equity Cost of Capital
 E
• Market value of equity in a levered firm.

 D
• Market value of debt in a levered firm.

 U
• Market value of equity in an unlevered firm.

 A
• Market value of the firm’s assets.

E  D  U  A
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14.3 Modigliani-Miller II: Leverage, Risk,
and the Cost of Capital (cont'd)

• Leverage and the Equity Cost of Capital

 The return on unlevered equity (RU) is related to the
returns of levered equity (RE) and debt (RD):
E D
RE  RD  RU
E  D E  D

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14.3 Modigliani-Miller II: Leverage, Risk,
and the Cost of Capital (cont'd)

• Leverage and the Equity Cost of Capital

 Solving for rE:

D
rE  rU  (rU  rD )
E
Risk without leverage
Additional risk due to leverage

• The levered equity return equals the unlevered return, plus a

premium due to leverage.
 The amount of the premium depends on the amount of leverage,
measured by the firm’s market value debt-equity ratio, D/E.

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14.3 Modigliani-Miller II: Leverage, Risk,
and the Cost of Capital (cont'd)

• Leverage and the Equity Cost of Capital

 MM Proposition II:
• The cost of capital of levered equity is equal to the cost of
capital of unlevered equity plus a premium that is
proportional to the market value debt-equity ratio.
• Cost of Capital of Levered Equity

D
rE  rU  (rU  rD )
E

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14.3 Modigliani-Miller II: Leverage, Risk,
and the Cost of Capital (cont'd)

• Leverage and the Equity Cost of Capital

 Recall from above:
• If the firm is all-equity financed, the expected return on
unlevered equity is 15%.
• If the firm is financed with $500 of debt, the expected return
of the debt is 5%.

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Example 14.4

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Capital Budgeting and the
Weighted Average Cost of Capital

• If a firm is unlevered, all of the free cash

flows generated by its assets are paid out to
its equity holders.
 The market value, risk, and cost of capital for the firm’s
assets and its equity coincide and, therefore:
rU  rA

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 Capital Budgeting and the
Weighted Average Cost of Capital (cont'd)

• If a firm is levered, project rA is equal to the firm’s

weighted average cost of capital.
 Weighted Average Cost of Capital (No Taxes)

 Fraction of Firm Value   Equity   Fraction of Firm Value   Debt 

rwacc          
 Financed by Equity   Cost of Capital   Financed by Debt   Cost of Capital 
E D
 rE  rD
E  D E  D

rwacc  rU  rA

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Figure 14.1
WACC and
Leverage
with Perfect
Capital Markets

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Chapter 14: Problem 12

Hardmon Enterprises is currently an all-equity firm with an expected

return of 12%. It is considering a leveraged recapitalization in which it
would borrow and repurchase existing shares.
a. Suppose Hardmon borrows to the point that its debt-equity ratio is
0.50. With this amount of debt, the debt cost of capital is 6%. What
will the expected return of equity be after this transaction?
b. Suppose instead Hardmon borrows to the point that its debt-equity
ratio is 1.50. With this amount of debt, Hardmon’s debt will be much
riskier. As a result, the debt cost of capital will be 8%. What will the
expected return of equity be in this case?
c. A senior manager argues that it is in the best interest of the
shareholders to choose the capital structure that leads to the highest
expected return for the stock. How would you respond to this
argument?

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Problem

Honeywell International Inc. (HON) has a market debt-

equity ratio of 0.5.
 Assume its current debt cost of capital is 6.5%, and its
equity cost of capital is 14%.
 If HON issues equity and uses the proceeds to repay its
debt and reduce its debt-equity ratio to 0.4, it will lower
its debt cost of capital to 5.75%.
 With perfect capital markets, what effect will this
transaction have on HON’s equity cost of capital
and WACC?

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Computing the WACC
with Multiple Securities
• If the firm’s capital structure is made up of multiple
securities, then the WACC is calculated by
computing the weighted average cost of capital of
all of the firm’s securities.

• Example: Suppose out entrepreneur decides to

sell the firm by splitting it into three securities.
Equity=440m, Debt=500m, and Warrents=60m.
The warrants will pay $20 when the firm’s cash
flows are high and nothing when the cash flows
are low. What is the WACC?
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Levered and Unlevered Betas

• The effect of leverage on the risk of a firm’s

securities can also be expressed in terms of beta:
E D
U  E  D
E  D E  D

D
 E  U  ( U   D )
E
D D
 E  U  U  (1  ) U
E E

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Alternative Example 14.7

• Problem
 Estimates of equity betas and market debt-equity ratios
for several stocks are shown below:

Name Equity Beta Debt-Equity Ratio Debt Beta

Kraft Foods Inc. 0.71 0.35 0.10
H.J. Heinz Co. 0.63 2.23 0.27
Lancaster Colony 0.87 0.00 0.00

 Calculate the unlevered beta for each of the firms?

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Cash and Net Debt

• Holding cash has the opposite effect of leverage

on risk and return and can be viewed as
equivalent to negative debt.

Net Debt  Debt  Cash and Risk-Free Securities

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Example

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14.4 Capital Structure Fallacies

• Leverage and Earnings per Share

 Leverage can increase a firm’s expected earnings per
share. This is sometimes used (incorrectly) as an
argument that leverage should also increase the firm’s
stock price.

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14.4 Capital Structure Fallacies (cont'd)

• Leverage and Earnings per Share

 Example:
• 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.

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14.4 Capital Structure Fallacies (cont'd)

• Leverage and Earnings per Share

 Example:
• Are shareholders better off?
 NO! 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.

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Figure 14.2
LVI Earnings
per Share
with and
without
Leverage

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Example 14.9

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Equity Issuances and Dilution

• 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

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Equity Issuances and Dilution (cont'd)
• Suppose Jet Sky Airlines (JSA) currently has no
debt and 500 million shares of stock outstanding,
currently trading at a price of $16  market value
of $8 billion.
• 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.
• 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.
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Equity Issuances and Dilution (cont'd)

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14.5 MM: Beyond the Propositions

• Conservation of Value Principle for

Financial Markets
 With perfect capital markets, financial transactions
neither add nor destroy value, but instead represent a
repackaging of risk (and therefore return).
• This implies that any financial transaction that appears
to be a good deal may be exploiting some type of
market imperfection.

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