© 2012 mcgraw-hill ryerson limitedchapter 16 -1 the value of a firm from two angles...
TRANSCRIPT
© 2012 McGraw-Hill Ryerson Limited Chapter 16 -1
The value of a firm from two angles
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© 2012 McGraw-Hill Ryerson Limited Chapter 16 -2
A firm’s capital structure is the mix of debt and equity its financial managers choose
Does the choice of capital structure affect the value of a firm
Modigliani and Miller (MM)◦ When there are no taxes and well functioning capital
markets exist, the market value of a company does not depend on its capital structure
◦ In other words, managers cannot increase firm value by changing the mix of securities used to finance the company
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© 2012 McGraw-Hill Ryerson Limited Chapter 16 -3
MM Assumptions:◦ Capital markets have to be “well functioning”
Investors can borrow/lend on the same terms as firms
Capital markets are efficient◦ There are no taxes or costs of financial distress
Example: in the next few slides, it is shown how the River Cruise company is operating now and how can it change its structure. At the end, it is shown that whatever it achieves by changing its structure, can be replicated by the shareholders themselves. MM called it the ‘home-made leverage’.
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© 2012 McGraw-Hill Ryerson Limited Chapter 16 -4
The River Cruise example: Current Structure
17.5%12.5%7.5% Return on Shares
1.751.25$.75shareper Earnings
175,000125,000$75,000IncomeOperating
BoomExpectedSlump
Economy the State ofOutcome
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© 2012 McGraw-Hill Ryerson Limited Chapter 16 -5
The River Cruise example: Proposed StructureIssue $500,000 of debt with a 10% coupon and use the funds to repurchase 50,000 shares at $10 apiece
500,000debtofueMarket val
500,000SharesofValueMarket
$10shareper Price
50,000sharesofNumber
Value of firm = D+E= $500,000 + $500,000 = $1 mill
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© 2012 McGraw-Hill Ryerson Limited Chapter 16 -6
Earnings and returns per share with debt
25%15%5%Return on shares
2.501.50$.50shareper Earnings
125,00075,000$25,000earningsEquity
50,00050,000$50,000Interest
175,000125,000$75,000IncomeOperating
BoomExpectedSlump
State of the Economy
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© 2012 McGraw-Hill Ryerson Limited Chapter 16 -7
If the firm did not borrow, but the shareholders borrowed $10 to buy one more share. This would make them have a debt of 50%, the same as that of the proposed firm structure.
25%15%5% investment$10 on Return
2.501.50$.50investment on earningsNet
1.001.00$1.0010% @Interest :LESS
3.502.50$1.50shares twoon Earnings
BoomExpectedSlump
Economy theof State Outcome
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© 2012 McGraw-Hill Ryerson Limited Chapter 16 -8
How borrowing affects risk and return
Firm Value:
All Equity Financing
After Restructuring
$1 million
Debt:
Equity:
$500,000
$500,000
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Even though the value of the firm remains unchanged, shareholders of the levered firm face a higher risk and therefore demand a higher return
© 2012 McGraw-Hill Ryerson Limited Chapter 16 -9
Restructuring does not affect operating income◦ The operating risk, or business risk, of the firm is
unchanged◦ However, with more debt in the capital structure, the
EPS becomes more risky. The financial risk of the firm increases.
MM’s Proposition II◦ The required return on a firm’s equity increases as
the firm’s debt-equity ratio increases
debtassetsassetsequity rrE
Drr
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© 2012 McGraw-Hill Ryerson Limited Chapter 16 -10
MM’s proposition II with constant rDebt
Note: rdebt need not be constant
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