CapitalStructureTheory.docx

Capital Structure Refers to the mix of debt and equity that a company uses to finance its business Capital Restructuring Capital restructuring involves changing the amount of leverage a firm has without changing the firm’s assets The firm can increase leverage by issuing debt and repurchasing outstanding shares The firm can decrease leverage by issuing new shares and retiring outstanding debt 1 Capital Structure Theory Modigliani and Miller Theory of Capital Structure Proposition I – firm value Proposition II – WACC The value of the firm is determined by the cash flows to the firm and the risk of the assets To change firm value Change the risk of the cash flows Change the cash flows 2 Capital Structure Theory Under Three Special Cases Case I – Assumptions No corporate or personal taxes No bankruptcy costs Case II – Assumptions Corporate taxes, but no personal taxes No bankruptcy costs Case III – Assumptions Corporate taxes, but no personal taxes Bankruptcy costs 3 Case I – Propositions I and II Value of the firm (Proposition I) The value of the firm is NOT affected by changes in the capital structure The cash flows of the firm do not change; therefore, value doesn’t change WACC (Proposition II) The WACC of the firm is NOT affected by capital structure 4 Case I - Equations WACC = RA = (E/V)RE + (D/V)RD RE = RA + (RA – RD)(D/E) RA is the “cost” of the firm’s business risk, i.e., the risk of the firm’s assets (RA – RD)(D/E) is the “cost” of the firm’s financial risk, i.e., the additional return required by stockholders to compensate for the risk of leverage 5 6 Case II Interest is tax deductible Therefore, when a firm adds debt, it reduces taxes, all else equal The reduction in taxes increases the cash flow of the firm How should an increase in cash flows affect the value of the firm? 7 Case II - Example Unlevered Firm Levered Firm EBIT 5,000 5,000 Interest 0 500 Taxable Income 5,000 4,500 Taxes (34%) 1,700 1,530 Net Income 3,300 2,970 CFFA 3,300 3,470 Interest Tax