Chapter 18
Dynamics Capital Structure
Decisions: Part II
MM and Miller models
Hamada’s equation
Financial distress and agency costs
Trade-off models
Asymmetric information theory
Who are Modigliani and Miller (MM)?
Theypublished theoretical papers that changed the
way people thought about financial leverage.
They won Nobel prizes in economics because of
their work.
MM’s papers were published in 1958 and 1963.
Miller had a separate paper in 1977. The papers
differed in their assumptions about taxes.
What Assumptions Underlie the MM
and Miller Models?
Firms can be grouped into homogeneous
classes based on business risk.
Investors have identical expectations about
firms’ future earnings.
There are no transactions costs.
(More...)
Alldebt is riskless, and both individuals
and corporations can borrow unlimited
amounts of money at the risk-free rate.
All cash flows are perpetuities. This
implies perpetual debt is issued, firms have
zero growth, and expected EBIT is constant
over time.
(More...)
MM’s first paper (1958) assumed zero
taxes. Later papers added taxes.
No agency or financial distress costs.
These assumptions were necessary for
MM to prove their propositions on the
basis of investor arbitrage.
MM with Zero Taxes (1958)
Proposition I:
VL = VU.
Proposition II:
rsL = rsU + (rsU - rd)(D/S).
Given the following data, find V, S,
rs, and WACC for Firms U and L.
Firms U and L are in same risk class.
EBITU,L = $500,000.
Firm U has no debt; rsU = 14%.
Firm L has $1,000,000 debt at rd = 8%.
The basic MM assumptions hold.
There are no corporate or personal taxes.
1. Find VU and VL.
EBIT $500,000
VU = = = $3,571,429.
rsU 0.14
VL = VU = $3,571,429.
Questions: What is the derivation of the
VU equation? Are the MM assumptions
required?
2. Find the market value of
Firm L’s debt and equity.
VL = D + S = $3,571,429
$3,571,429 = $1,000,000 + S
S = $2,571,429.
3. Find rsL.
rsL = rsU + (rsU - rd)(D/S)
( )
$1,000,000
= 14.0% + (14.0% - 8.0%) $2,571,429
= 14.0% + 2.33% = 16.33%.
4. Proposition I implies WACC = rsU.
Verify for L using WACC formula.
WACC = wdrd + wcers = (D/V)rd + (S/V)rs
= (
$1,000,000
$3,571,429
)(8.0%)
+( )
$2,571,429
(16.33%)
$3,571,429
= 2.24% + 11.76% = 14.00%.
Graph the MM Relationships Between
Capital Costs and Leverage as Measured by
D/V.
Cost of Without taxes
Capital (%)
26 rs
20
14 WACC
rd
8
Debt/Value
0 20 40 60 80 100 Ratio (%)
The more debt the firm adds to its capital
structure, the riskier the equity becomes
and thus the higher its cost.
Although rd remains constant, rs increases
with leverage. The increase in rs is exactly
sufficient to keep the WACC constant.
Graph Value versus Leverage.
Value of Firm, V (%)
4
VU VL
3
Firm value ($3.6 million)
2
1
0 0.5 1.0 1.5 2.0 2.5
Debt (millions of $)
With zero taxes, MM argue that value is
unaffected by leverage.
Find V, S, rs, and WACC for Firms U
and L Assuming a 40% Corporate
Tax Rate.
With corporate taxes added, the MM
propositions become:
Proposition I:
VL = VU + TD.
Proposition II:
rsL = rsU + (rsU - rd)(1 - T)(D/S).
Notes About the New Propositions
1. When corporate taxes are added,
VL VU. VL increases as debt is added
to the capital structure, and the greater
the debt usage, the higher the value of the
firm.
2. rsL increases with leverage at a slower
rate when corporate taxes are considered.
1. Find VU and VL.
VU =
EBIT(1 - T) =
$500,000(0.6) = $2,142,857.
rsU 0.14
Note: Represents a 40% decline from the no taxes
situation.
VL = VU + TD = $2,142,857 + 0.4($1,000,000)
= $2,142,857 + $400,000
= $2,542,857.
2. Find Market Value of Firm
L’s Debt and Equity.
VL = D + S = $2,542,857
$2,542,857 = $1,000,000 + S
S = $1,542,857.
3. Find rsL.
rsL = rsU + (rsU - rd)(1 - T)(D/S)
= 14.0% + (14.0% - 8.0%)(0.6) ( )
$1,000,000
$1,542,857
= 14.0% + 2.33% = 16.33%.
4. Find Firm L’s WACC.
WACCL = (D/V)rd(1 - T) + (S/V)rs
$1,000,000
( )
= $2,542,857 (8.0%)(0.6)
$1,542,857
( )
+ $2,542,857 (16.33%)
= 1.89% + 9.91% = 11.80%.
When corporate taxes are considered, the WACC
is lower for L than for U.
MM Relationship Between Capital Costs
and Leverage when Corporate Taxes are
Considered.
Cost of
Capital (%)
rs
26
20
14
WACC
8 rd(1 - T)
Debt/Value
0 20 40 60 80 100 Ratio (%)
MM Relationship Between Value and Debt
when Corporate Taxes are Considered.
Value of Firm, V (%)
4
VL
3 TD
2 VU
1 Debt
0 0.5 1.0 1.5 2.0 2.5 (Millions of $)
Under MM with corporate taxes, the firm’s value increases
continuously as more and more debt is used.
Assume Investors have the Following Tax
Rates: Td = 30% and Ts = 12%. What is
the Gain from Leverage According to the
Miller Model?
Miller’s Proposition I:
[
VL = VU + 1 - (1 - Td) ]
(1 - Tc)(1 - Ts)
D.
Tc = corporate tax rate.
Td = personal tax rate on debt income.
Ts = personal tax rate on stock income.
Tc = 40%, Td = 30%, and Ts = 12%.
[ ]
VL = VU + 1 - (1 - 0.40)(1 - 0.12) D
(1 - 0.30)
= VU + (1 - 0.75)D
= VU + 0.25D.
Value rises with debt; each $100 increase in
debt raises L’s value by $25.
How does this Gain Compare to the
Gain in the MM Model with Corporate
Taxes?
If only corporate taxes, then
VL = VU + TcD = VU + 0.40D.
Here $100 of debt raises value by $40.
Thus, personal taxes lowers the gain from
leverage, but the net effect depends on tax
rates.
(More...)
If Ts declines, while Tc and Td remain
constant, the slope coefficient (which shows
the benefit of debt) is decreased.
A company with a low payout ratio gets
lower benefits under the Miller model than
a company with a high payout, because a
low payout decreases Ts.
When Miller Brought in Personal
Taxes, the Value Enhancement of
Debt was Lowered. Why?
1. Corporate tax laws favor debt over equity
financing because interest expense is tax
deductible while dividends are not.
(More...)
2. However, personal tax laws favor equity
over debt because stocks provide both tax
deferral and a lower capital gains tax rate.
3. This lowers the relative cost of equity vis-
a-vis MM’s no-personal-tax world and
decreases the spread between debt and
equity costs.
4. Thus, some of the advantage of debt
financing is lost, so debt financing is less
valuable to firms.
What does Capital Structure Theory
Prescribe for Corporate Managers?
1. MM, No Taxes: Capital structure is irrelevant--
no impact on value or WACC.
2. MM, Corporate Taxes: Value increases, so
firms should use (almost) 100% debt financing.
3. Miller, Personal Taxes: Value increases, but less
than under MM, so again firms should use
(almost) 100% debt financing.
Do Firms follow the Recommendations
of Capital Structure Theory?
1. Firms don’t follow MM/Miller to 100%
debt. Debt ratios average about 40%.
2. However, debt ratios did increase after MM.
Many think debt ratios were too low, and
MM led to changes in financial policies.
How is all of this analysis different if
firms U and L are growing?
Under MM (with taxes and no growth)
VL = VU + TD
This assumes the tax shield is discounted
at the cost of debt.
Assume the growth rate is 7%
The debt tax shield will be larger if the
firms grow:
7% growth, TS discount rate of rTS
Value of (growing) tax shield =
VTS = rdTD/(rTS – g)
So value of levered firm =
VL = VU + rdTD/(rTS – g)
What should rTS be?
The smaller is rTS, the larger the value
of the tax shield. If rTS < rsU, then with
rapid growth the tax shield becomes
unrealistically large—rTS must be equal
to rU to give reasonable results when
there is growth. So we assume rTS =
rsU.
Levered cost of equity
Inthis case, the levered cost of equity is rsL
= rsU + (rsU – rd)(D/S)
This looks just like MM without taxes even
though we allow taxes and allow for
growth. The reason is if rTS = rsU, then
larger values of the tax shield don't change
the risk of the equity.
Levered Beta
If there is growth and rTS = rsU then the
equation that is equivalent to the Hamada
equation is
L = U + (U - D)(D/S)
Notice: This looks like Hamada without
taxes. Again, this is because in this case
the tax shield doesn't change the risk of the
equity.
Relevant Information for Valuation
EBIT = $500,000
T = 40%
rU = 14% = rTS
rd = 8%
Required reinvestment in net operating
assets = 10% of EBIT = $50,000.
Debt = $1,000,000
Calculating VU
NOPAT = EBIT(1-T)
= $500,000 (.60) = $300,000
Investment in net op. assets
= EBIT (0.10) = $50,000
FCF = NOPAT – Inv. in net op. assets
= $300,000 - $50,000
= $250,000 (this is expected FCF next year)
Value of unlevered firm, VU
Value of unlevered firm =
VU = FCF/(rsU – g)
= $250,000/(0.14 – 0.07)
= $3,571,429
Value of Tax Shield, VTS and VL
VTS = rdTD/(rsU –g)
= 0.08(0.40)$1,000,000/(0.14-0.07)
= $457,143
VL = VU + VTS
= $3,571,429 + $457,143
= $4,028,571
Cost of Equity and WACC
Just like with MM with taxes, the cost of
equity increases with D/V, and the WACC
declines.
But since rsL doesn't have the (1-T) factor in
it, for a given D/V, rsL is greater than MM
would predict, and WACC is greater than
MM would predict.
Costs of capital for MM and Extension
40.00%
35.00%
Cost of Capital
30.00% MM rsL
25.00%
MM WACC
20.00%
Extension rsL
15.00%
10.00% Extension WACC
5.00%
0.00%
0% 20% 40% 60% 80% 100%
D/V
What if L's Debt is Risky?
If L's debt is risky then, by definition,
management might default on it. The
decision to make a payment on the debt
or to default looks very much like the
decision whether to exercise a call
option. So the equity looks like an
option.
Equity as an Option
Suppose the firm has $2 million face value of
1-year zero coupon debt, and the current
value of the firm (debt plus equity) is $4
million.
If the firm pays off the debt when it matures,
the equity holders get to keep the firm. If
not, they get nothing because the debtholders
foreclose.
Equity as an Option
The equity holder's position looks like a call
option with
P = underlying value of firm = $4 million
X = exercise price = $2 million
t = time to maturity = 1 year
Suppose rRF = 6%
= volatility of debt + equity = 0.60
Use Black-Scholes to Price this
Option
V = P[N(d1)] - Xe -rRFt[N(d2)].
ln(P/X) + [rRF + (2/2)]t
d1 =
.
t
d2 = d1 - t.
Black-Scholes Solution
V = $4[N(d1)] - $2e-(0.06)(1.0)[N(d2)].
ln($4/$2) + [(0.06 + 0.36/2)](1.0)
d1(0.60)(1.0)
=
= 1.5552.
d2 = d1 - (0.60)(1.0) = d1 - 0.60
= 1.5552 - 0.6000 = 0.9552.
N(d1) = N(1.5552) = 0.9401
N(d2) = N(0.9552) = 0.8383
Note: Values obtained from Excel using
NORMSDIST function.
V = $4(0.9401) - $2e-0.06(0.8303)
= $3.7604 - $2(0.9418)(0.8303)
= $2.196 Million = Value of Equity
Value of Debt
The value of debt must be what is left
over:
Value of debt = Total Value – Equity
= $4 million – 2.196 million
= $1.804 million
This Value of Debt gives us a Yield
Debt yield for 1-year zero coupon debt
= (face value / price) – 1
= ($2 million/ 1.804 million) – 1
= 10.9%
How does Affect an Option's
Value?
Higher volatility means higher
option value.
Managerial Incentives
When an investor buys a stock option, the
riskiness of the stock () is already
determined. But a manager can change a
firm's by changing the assets the firm
invests in. That means changing can
change the value of the equity, even if it
doesn't change the expected cash flows:
Managerial Incentives
So changing can transfer wealth from
bondholders to stockholders by making
the option value of the stock worth
more, which makes what is left, the
debt value, worth less.
Values of Debt and Equity for Different Volatilities
3.00
2.50
Value (millions)
2.00
Equity
1.50
Debt
1.00
0.50
0.00
0.00 0.20 0.40 0.60 0.80 1.00
Volatility (sigma)
Bait and Switch
Managers who know this might tell
debtholders they are going to invest in one
kind of asset, and, instead, invest in riskier
assets. This is called bait and switch and
bondholders will require higher interest rates
for firms that do this, or refuse to do business
with them.
If the Debt is Risky Coupon Debt
If the risky debt has coupons, then with
each coupon payment management has
an option on an option—if it makes the
interest payment then it purchases the
right to later make the principal
payment and keep the firm. This is
called a compound option.
