Review

We saw three consequences of a competitive

capital market
Value additivity
NPV rule
Irrelevance of capital structure
Now we will see 1) The irrelevance result from a
different perspective 2) The cost of capital view and
applications

Capital structure and arbitrage

Consider two identical firms in a competitive

market with only one period and two states
The cash flows in millions are
Cash flow
firm A

Cash flow
firm B

state 1

160

160

state 2

40

40
1-2

Capital structure and

arbitrage (cont)

Suppose A does not have debt in its

structure while B has issue debt with a
value (equal to its face value) of 30
millions with a discount rate of 10%. The
shares of B have a value of 70 million
and the value As shares is 110is there
an arbitrage opportunity?.

The MM Propositions I & II (No Taxes)

Proposition I

Firm value is not affected by leverage

VL = VU

Proposition II

Leverage increases the risk and return to stockholders

rs = r0 + (B / SL) (r0 - rB)
rB is the interest rate (cost of debt)
rs is the return on (levered) equity (cost of equity)
r0 is the return on unlevered equity (cost of capital)
B is the value of debt
SL is the value of levered equity

B
rrWACS
0B
(B

)
0
S
L
S
rSBB

rS

Cost of capital: r
(%)

The Cost of Equity, the Cost of Debt, and the Weighted

Average Cost of Capital: MM Proposition II with No
Corporate Taxes

r0

rB

rB

Debt-to-equity
Ratio

B
S

The MM Propositions I & II

(with Corporate Taxes)

Proposition I (with Corporate Taxes)

Firm value increases with leverage

V L = V U + TC B

Proposition II (with Corporate Taxes)

Some of the increase in equity risk and return is offset by

interest tax shield
rS = r0 + (B/S)(1-TC)(r0 - rB)
rB is the interest rate (cost of debt)
rS is the return on equity (cost of equity)
r0 is the return on unlevered equity (cost of capital)
B is the value of debt
S is the value of levered equity

B
rSS

(
r

)
0B
0
S
L
T

(
r
)
0L1
C
0
B
S
L
rWACB

r
(
1

T
)

rS
B
C
SLB

The Effect of Financial Leverage on the Cost of

Debt and Equity Capital with Corporate Taxes
Cost of capital: r
(%)

r0

rB

Debt-to-equity
ratio (B/S)

Total Cash Flow to Investors Under

Each Capital Structure with Corp.
Taxes
All-equity firm
S

Levered firm
S

The levered firm pays less in taxes than does the all-equity firm.
Thus, the sum of the debt plus the equity of the levered firm is greater
than the equity of the unlevered firm.

15-8

Total Cash Flow to Investors Under

Each Capital Structure with Corp. Taxes
All-Equity
EBIT
Interest
EBT
Taxes (Tc = 35%
Total Cash Flow to S/H

EBIT
Interest ($800 @ 8% )
EBT
Taxes (Tc = 35%)
Total Cash Flow
(to both S/H & B/H):
EBIT(1-Tc)+TCrBB

Recession
$1,000
0
$1,000
$350

Expected
$2,000
0
$2,000
$700

Expansion
$3,000
0
$3,000
$1,050

$650

$1,300

$1,950

LeveredRecessionExpected

Expansion

$1,000$2,000
$3,000
640640
640
$360$1,360
$2,360
$126$476
$826
$234+640$468+$640$1,534+$640
$874$1,524
$2,174
$650+$224$1,300+$224$1,950+$224
$874$1,524
$2,174

Example1

Suppose the total value of a levered firm

is $300 million and the value of its debt
(perpetual)is $75 million. Suppose the
cost of debt is 10% and the tax rate is
34%. Finally, if the firm would be
unlevered assume its cost of capital
should be 15%.

Example 1 (cont)

What should be the expected return for

the shareholders?

What should be the WACC?

Example 1 (cont)

What would be the value of the firm

without leverage?

What if the value of debt is $2 million?

Example2

Suppose a firm is financed only with

equity and its EBIT is $3,5 millions per
year(perpetuity). Ro is 20% and the tax
rate is 34%. If the firm issues debt its
cost would be 12%.
What is the firm value?

Example 2 (cont)

What should be the WACC if the firm

decides to finance 30% of its value with
debt?

If the firm instead of 30% debt the firm

issues $3 million debt to buy back
shares, what should be the value of Rs ?