McGraw-Hill/Irwin Copyright © 2015 by The McGraw-Hill Companies, Inc. All rights reserved.

“You can observe a lot

by watching”

Yogi Berra

Professor James J. Barkocy

Principles of Corporate Finance

2

Value and Capital Structure

AssetsLiabilities and

Stockholder’s EquityValue of cash flows from

firm’s real assets and

operations Market value of debt

Market value of equity

Value of Firm Value of Firm

3

M&M (Debt Policy Doesn’t Matter)

• When there are no taxes and capital markets function well, the market value of a company does not depend on its capital structure. In other words, financial managers cannot increase value by changing the mix of securities used to finance the company.

Modigliani & Miller

Firm A Firm B

Type of Firm All Equity Some equity & some debt

V=E V= D+E

Action Taken Investor buys Investor buys fraction “a”

“a” of equity of both debt and equity

aV aD + aE = a(D+E)=aV

Next period Investor receives Investor receives the

a fraction of CF following

aX a(X-rD)+ arD = aX

Note: X-rD is the cash flow less interest expense

arD is the “piece” of interest that goes to the investor4

M&M’s Proof

Example - River Cruises - All Equity Financed

17.5%12.5%7.5% shares on Return

1.751.25$.75shareper Earnings

175,000125,000$75,000Income Operating

BoomExpectedSlump

Economy theof State Outcome

million 1 $Shares of ValueMarket

$10shareper Price

100,000shares ofNumber

Data

5

M&M (Debt Policy Doesn’t Matter)

50% debt

25%15%5% shares on Return

2.501.50$.50shareper Earnings

125,00075,000$25,000earningsEquity

50,00050,000$50,000Interest

175,000125,000$75,000Income Operating

BoomExpectedSlump

Economy theof State Outcome

500,000 $debt of ueMarket val

500,000 $Shares of ValueMarket

$10shareper Price

50,000shares ofNumber

Data

FYI: interest

rate is 10%

6

M&M - Debt Policy Doesn’t Matter

7

M&M Proposition II

8

Capital Structure & Taxes

Example - You own all the equity of Space Babies DiaperCo. The company has no debt. The company’s annualcash flow is $10,000, before interest and taxes. Thecorporate tax rate is 21%. You have the option toexchange part of your equity position for 6% bondswith a face value of $50,000.

Should you do this and why?

9

Example - You own all the equity of Space Babies Diaper Co. The company has

no debt. The company’s annual cash flow is $10,000, before interest and taxes.

The corporate tax rate is 21%. You have the option to exchange part of your

equity position for 6% bonds with a face value of $50,000.

Should you do this and why?

Capital Structure & Taxes

All Equity ½ Debt

EBIT 10,000 10,000

Interest Payment 0 3,000

Pretax Income 10,000 7,000

Taxes @ 21% 2,100 1,470

Net Cash Flow 7,900 5,530

10

Total Cash Flow

All Equity = 7,900

*1/2 Debt = 8,530

(5,530 + 3,000)

Example - You own all the equity of Space Babies Diaper Co. The company has no

debt. The company’s annual cash flow is $10,000, before interest and taxes. The

corporate tax rate is 21%. You have the option to exchange part of your equity

position for 6% bonds with a face value of $50,000.

Should you do this and why?

Capital Structure & Taxes

All Equity ½ Debt

EBIT 10,000 10,000

Interest Payment 0 3,000

Pretax Income 10,000 7,000

Taxes @ 21% 2,100 1,470

Net Cash Flow 7,900 5,530

11

Capital StructureFirm Value =

Value of All Equity Firm + PV Tax Shield

Example

All Equity Value = 100,000

PV Tax Shield = D x Tc = 50000 x .21 =$10,500

Firm Value with 1/2 Debt = $110,500

12

Tax Shield and Value

13

Financial Distress

Costs of Financial Distress - Costs arising from

bankruptcy or distorted businessdecisions before

bankruptcy.

Market Value = Value if all Equity Financed

+ PV Tax Shield

- PV Costs of Financial Distress

14

Financial Distress

Debt

Mar

ket

Val

ue

of

The

Fir

m

Value ofunlevered

firm

PV of interesttax shields

Costs offinancial distress

Value of levered firm

Optimal amount of debt

Maximum value of firm

15

Financial ChoicesTrade-off Theory - Theory that capital structure

is based on a trade-off between tax savings

and distress costs of debt.

Pecking Order Theory - Theory stating that firms

prefer to issue debt rather than equity if internal

finance is insufficient.

Internal Equity – plowback

Debt

External Equity – new issue

Financial Slack