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Roadmap
Overview of Modigliani-Miller Propositions I
ES D
E D
S
BB
S
E
D
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Intuition
We can create a levered or
(un)levered position by adjusting
the trading in our own account.
This homemade leverage
suggests that capital structure is
irrelevant in determining the value
of the firm:VL = VU
Corporate Finance Lecture Note 1
RecessionExpected Expansion
EPS of Unlevered Firm$2.50 $5.00
$7.50
Earnings for 40 shares $100
$200
$300
Less interest on $800 (8%)$64 $64
$64
Net Profits
$36
$136
$236
ROE (Net Profits / $1,200) 3.0% 11.3% 19.7%
We are buying 40 shares of a $50 stock, using $800 in
margin. We get the same ROE as if we bought into a
levered firm.
D
$800 2
Homemade (Un)Leverage: An
Example
RecessionExpected Expansion
EPS of Levered Firm $1.50$5.67$9.83
Earnings for 24 shares $36$136$236
Plus interest on $800 (8%)$64 $64$64
Net Profits
$100$200$300
ROE (Net Profits / $2,000) 5%10%15%
Buying 24 shares of an otherwise identical levered firm
along with some of the firms debt gets us to the ROE of the
unlevered firm.
This is the fundamental insight of M&M
Corporate Finance Lecture Note 1
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In-Class Exercise
Firm has a total market value of $150,000 under
no debt. EBIT (Earnings before interest and
taxes) is $14,000 under normal case and is 40%
higher if in expansion and is 70% lower when it
is recession. There are currently 2,500 shares
outstanding.
1. Calculate EPS (Earnings per share)
2.Repeat 1 when the firms issues $60,000 to
buyback the shares in the open market.
Corporate Finance Lecture Note 1
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In-Class Exercise
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Roadmap
MM Proposition II (No Taxes)
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D
RE = RA +
(R A R D )
E
Where D and E are the market values of debt and
equity and
EBIT
EBIT
RA =
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A
A
A
by MMI, A=D+E, so
CFA
CFD CFE
CFD
CFE
D
E
(
)
(
),
A
D+E
D
D+E
E
D+E
D
E
Thus, R A = R D (
)+R E (
)
D+E
D+E
Algebraic rearrangement gives the result
Corporate Finance Lecture Note 1
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D
( RA RD )
E
RA
RA
RD
RD
Debt-to-equity Ratio
Corporate Finance Lecture Note 1
D
E
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In-Class Exercise
Please evaluate the following argument:
Equity is cheap because the firm does not
have to pay investors any dividends if it
does not want to.
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D
R E = R A + (R A R D ) 10% 10 / 40*(10% 4%) 11.5%
E
EPS=(5-10*0.04)/4=$1.15/share
P/E=10/1.15=8.7
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Continued
The CEO decides to boost the P/E ratio in
order to increase shareholder value. The
firm issues 1 million new shares at
$10/share and uses the proceeds to buy
back all its debt.
What are the EPS and P/E ratio?
Can you evaluate the firms based on the
P/E ratio and EPS?
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24
500
100
40
500
6.4
80
6.25
40
Can you evaluate the firms based on the P/E ratio and EPS?
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Roadmap
Corporate Tax Shield
MM Propositions I and II (with Taxes)
The implication of optimal debt level under
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EBIT (1 TC ) RD D (1 TC ) RD D
EBIT (1 TC ) RD D RD DTC RD D
The present value of the first term is VU
The present value of the second term is TCD
VL VU TC D
Corporate Finance Lecture Note 1
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Equity
TAXES
Equity
Debt
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D
R E = R A + (1 TC )(R A R D )
E
Where D and E are the market values of debt and
equity and
EBIT
EBIT
RA =
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Proof:
Let total market value of the assets, debt, and equity as A, D, and
E, respectively
(
)
(
)
VU
VU
D+E
VU
D+E
D+E CFD (1 TC )
D
D+E CFE
E
(
)
(
),
VU
D
D+E
VU
E
D+E
Thus, R A =
D
E
(1 TC )R D +R E (
)
VU
VU
V
E
D
D
) RA
(1 TC )R D , R E R A U
(1 TC )R D
VU
VU
E
E
D
(1 TC )(R A -R D )
E
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VL = VU + TCD
Maximum
firm value
VU = Value of firm with no debt
0
D
Optimal amount of debt
Debt (D)
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In-Class Exercise
Ross, Westerfield, and Jaffe Question 2 (pp.
449)
Firm has a total market value of $150,000 under
no debt. EBIT (Earnings before interest and
taxes) is $14,000 under normal case and is 40%
higher if in expansion and is 70% lower when it
is recession. The corporate tax rate is 40%.
There are currently 2,500 shares outstanding.
1. Calculate EPS (Earnings per share)
2.Repeat 1 when the firms issues $60,000 to
buyback the shares in the open market. Debt
pays 5% interest.
Corporate Finance Lecture Note 1
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EBIT
Interest
Taxes
NI
EPS
%EPS
Recession
Normal
Expansion
$4,200
$14,000
$19,600
1,680
5,600
7,840
$2,520
$8,400
$11,760
$1.01
$3.36
$4.70
70
+40
Recession
Normal
Expansion
$4,200
$14,000
$19,600
3,000
3,000
3,000
480
4,400
6,640
NI
$720
$6,600
$9,960
EPS
$.48
$4.40
$6.64
89.09
+50.91
EBIT
Interest
Taxes
%EPS
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Roadmap
What are the costs of financial distress?
What are the direct and indirect costs of
financial distress
The implication of optimal debt level under
MM Propositions I and II with significant costs
of financial distress
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Financial Distress
Costs of Financial Distress - Costs arising from
bankruptcy or distorted business decisions
before bankruptcy.
Market Value = Value if all Equity Financed
+ PV Tax Shield
- PV Costs of Financial
Distress
Corporate Finance Lecture Note 1
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VL = VU + TCD
Maximum
firm value
Present value of
financial distress costs
V = Actual value of firm
VU = Value of firm with no debt
0
D
Optimal amount of debt
Debt (D)
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Personal Taxes
If TS= TB then the firm should be financed
primarily by debt (avoiding double tax).
The firm is indifferent between debt and
equity when:
(1-TC) x (1-TS) = (1-TB)
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Background information:
1. There are two equally probable states of
nature. The true state is revealed to
management at t=0 and to investors at t=1.
2. The firm has no cash and the firms want to
issue stock to raise $100.
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Good
Bad
No New Equity
$250
$130
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Good news
Bad news
Do Nothing
$250.00
$130.00
Corporate Finance Lecture Note 1
Issue Equity
$229.31
$150.69
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Issue
$250.00
$230
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Conclusion
What are the Modigliani-Miller Propositions I and
II under perfect world?
What are the implications of optimal debt level
under Modigliani-Miller Propositions I and II?
What are the Modigliani-Miller Propositions I and
II with corporate taxes?
What are the implications of optimal debt level
under Modigliani-Miller Propositions I and II with
corporate taxes?
Why the stock price drops when there is an
Stock-for-debt exchange offer?
Corporate Finance Lecture Note 1
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