Home made leverage, Modigliani & Miller Model, How WACC remains constant, Business & Financial Risk, M & M model with taxes

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Corporate Finance FIN 622

Lesson 21

CAPITAL STRUCTURE & COST OF EQUITY

MODIGLIANI AND MILLER MODEL

The following topics will be discussed in this lecture.

Home made leverage

Modigliani & Miller Model

How WACC remains constant?

Business & Financial Risk

M & M model with taxes

1. Home made leverage

An investor can change the overall financial leverage to which he is exposed, by the use of personal

borrowing and investing it.

A substitution of risks that investors may undergo in order to move from overpriced shares in highly

levered firms to those in un-levered firms by borrowing in personal accounts.

Mainly attributed to the Modigliani-Miller Theorem, homemade leverage describes the situation where

individuals borrowing on the exact same terms as large firms can duplicate corporate leverage through

purchasing and financing options.

2. Modigliani & Miller Model

A financial theory stating that the market value of a firm is determined by its earning power and the risk of

its underlying assets, and is independent of the way it chooses to finance its investments or distribute

dividends. Remember, a firm can choose between three methods of financing: issuing shares, borrowing

and spending profits (as opposed to dispersing them to shareholders in dividends). The theorem gets

much more complicated, but the basic idea is that, under certain assumptions, it makes no difference

whether a firm finances itself with debt or equity.

Notes:

In "Financial Innovations and Market Volatility" Merton Miller explains the concept using the following

analogy:

"Think of the firm as a gigantic tub of whole milk. The farmer can sell the whole milk as is. Or he can

separate out the cream and sell it at a considerably higher price than the whole milk would bring. (That's the

analog of a firm selling low-yield and hence high-priced debt securities.) But, of course, what the farmer

would have left would be skim milk with low butterfat content and that would sell for much less than whole

milk. That corresponds to the levered equity. The M and M proposition says that if there were no costs of

separation (and, of course, no government dairy-support programs), the cream plus the skim milk would

bring the same price as the whole milk."

Modigliani-Miller theorem

The Modigliani-Miller theorem forms the basis for modern thinking on capital structure. The basic

theorem states that, in the absence of taxes, bankruptcy costs, and asymmetric information and in an

efficient market, the value of a firm is unaffected by how that firm is financed. It does not matter if the

firm's capital is raised by issuing stock or selling debt. It does not matter what the firm's dividend policy is.

3. How WACC remains constant?

A calculation of a firm's cost of capital in which each category of capital is proportionately weighted. All

capital sources - common stock, preferred stock, bonds and any other long-term debt - are included in a

WACC calculation.

WACC is calculated by multiplying the cost of each capital component by its proportional weight and then

summing:

Where:

Corporate Finance FIN 622

Re = cost of equity

Rd = cost of debt

E = market value of the firm's equity

D = market value of the firm's debt

V=E+D

E/V = percentage of financing that is equity

D/V = percentage of financing that is debt

Tc - = corporate tax rate

The weight age average cost of capital will be constant if the proportionate of weight age of all sources

remains constant i.e. common stock, preferred stock, bonds and any other long term debt. And also the

return on common & preferred stock and interest on debt remains constant, then WACC remains constant.

When we talk about WACC remains constant we actually mean that any combination of debt & equity from

100% will not alter the overall cost of capital. That means that if you slice bread into four pieces and then

each piece into two to make total of eight pieces. Now you have more pieces but not more bread.

CAPITAL STRUCTURE

CURRENT STATUS

COMBINATIONS

Rs.

ASSETS

6,000,000.00 6,000,000.00 6,000,000.00 6,000,000.00

6,000,000.00

DEBT

2,000,000.00 3,000,000.00 4,000,000.00

5,000,000.00

EQUITY

6,000,000.00 4,000,000.00 3,000,000.00 2,000,000.00

1,000,000.00

DEBT/EQUITY

RATIO

0.50

1.00

2.00

5.00

SHARE PRICE

20.00

SHARES

OUTSTANDING

300,000.00

200,000.00

150,000.00

100,000.00

50,000.00

INTEREST RATE

10.00

EBIT

800,000.00

ROE

13.33

15.00

16.67

20.00

30.00

EPS

2.67

4.00

5.33

8.00

16.00

WACC

13.33

What we mean from 100% or bread in above example corresponds to total capitalization in the above chart.

We have various debt equity combinations in above chart but the total capitalization in every case is 6

million. This is the basis of our statement WACC remains constant.

4. Business & Financial Risk

Business Risk

Risk associated with the unique circumstances of a particular company, as they might affect the price of that

company's securities.

Corporate Finance FIN 622

Risks can fester and spread anywhere inside an organization. Many are industry-specific, such as the

regulatory concerns within financial services and healthcare. Others are common to all industries, such as

supply chain capacity, financial reporting reliability, human resources availability, and consumer relationship

integrity. Productivity specialist's help you identify, prioritize, and manage risks so that you can enhance

performance and ultimately, business value.

Financial Risk

· An assessment of the possibility that a given investment or loan will fail to bring a return and may

result in a loss of the original investment or loan.

· The risk that a company will not have adequate cash flow to meet financial obligations

· The risk that an investment will be unable to return profit to an investor.

5. M & M Model with Taxes

A financial theory stating that the market value of a firm is determined by its earning power and the risk of

its underlying assets, and is independent of the way it chooses to finance its investments or distribute

dividends. Remember, a firm can choose between three methods of financing: issuing shares, borrowing or

spending profits (as opposed to dispersing them to shareholders in dividends). The theorem gets much

more complicated, but the basic idea is that, under certain assumptions, it makes no difference whether a

firm finances itself with debt or equity.

Notes:

With Taxes

Proposition 1:

· VL is the value of a levered firm.

· VU is the value of an un-levered firm.

· TCB is the tax rate(T_C) x the value of debt (B)

This means that there are advantages for firms to be levered, since corporations can deduct interest

payments. Therefore leverage lowers tax payments. Dividend payments are non-deductible.

Proposition 2:

· Rs - is the cost of equity.

· r0 is the cost of capital for an all equity firm.

· rB is the cost of debt.

· B/S - is the debt-to-equity ratio.

· Tc - is the tax rate.

The same relationship as earlier described stating that the cost of equity rises with leverage, because the risk

to equity rises, still holds. The formula however has implications for the difference with the WACC.

The following assumptions are made in the propositions with taxes:

· corporations are taxed at the rate TC on earnings after interest,

· no transaction cost exist, and

· individuals and corporations borrow at the same rate

· Debt is for ever.

Concluding the discussion, the after tax cash flow of two identical firms in terms of EBIT but having

different capital structure debt equity weight age will effect the value of firm. This is because debt in

capital structure provides tax shield as interest on debt is tax deductible expense. Thus tax shield increases

the value of firm: a levered firm's value is greater than the un-levered firm.

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