Introduction to Corporate Finance

PART 4: CAPITAL STRUCTURE AND PAYOUT POLICY

all the securities the company issues and is invariant to the amount of debt or equity used.^4 Finally, the

cash flows generated by the company’s assets are risky, and investors discount them at the rate ra. M&M’s

Proposition I claims the following:

Eq. 13.1 V DE

EBIT

r

()

a

=+=

In terms of the company’s capital structure, Equation 13.1 indicates that the company’s market value

equals the present value of the EBIT it generates regardless of the capital structure it chooses. The market

value of any company is independent of its capital structure and is calculated by discounting expected

EBIT at the rate ra, appropriate for the company’s business risk. The discount rate ra is the required

return on assets, and is based on the variability of expected EBIT. This is exactly what Ms Kelly did for

HTMC. She generated an expected level of operating profits for HTMC ($1,000,000 EBIT per year),

and then discounted this stream of expected earnings, using a discount rate (ra = 10%), appropriate to

the business risk that HTMC faces. Company value is thus determined by the level of HTMC’s net

operating income and by the company’s degree of business risk, not by whether the EBIT stream is then

allocated entirely to shareholders in the all-equity capital structure or split between debt-and-equity

security holders under the proposed capitalisation.

Under HTMC’s current, all-equity capital structure, the return on equity is the same as the return

on the company’s assets: both ROA and ROE are 10%. But what happens if HTMC issues low-risk debt

and uses the proceeds to repurchase half the company’s outstanding equity? The company’s business

risk (the variability of expected EBIT) is unchanged by this transaction, and all this risk is still borne

by shareholders. However, the risk for shareholders is now magnified, because there is only half as

much equity outstanding as before. By how much will the risk to HTMC’s shareholders be magnified if

the company adopts the proposed 50% debt/50% equity capital structure? It turns out that M&M also

provided an answer to this question, with their Proposition II.

13 -2b M&M PROPOSITION II: HOW INCREASING LEVERAGE

AFFECTS THE COST OF EQUITY

Modigliani and Miller’s Proposition II asserts the following: if we hold the required return on assets (ra) and

the required return on debt (rd) constant, the expected return on levered equity (rl) increases with the

debt-to-equity ratio. Equation 13.2 expresses this relationship mathematically:

Eq. 13.2 rl = ra + (ra − rd)

D

E









Does this formula yield the same expected returns on equity for HTMC’s shareholders that Susan

Kelly had calculated earlier under the current all-equity and the proposed 50% debt/50% equity capital

structures? Remember that the company’s underlying business risk justifies a return, ra, of 10% and that

its cost of debt, rd, is 6%. Clearly, under the current all-equity structure, there is no debt outstanding,

and the D/E ratio is zero. Therefore, the term to the right of the plus sign in Equation 13.2 is also zero.

Equation 13.2 says that the return on equity equals the return on assets, or 10%:

r=0.10+−×(0.1 00 .06) ==

$0

$10,000, 000

l 0.10 10%

4 We are not speaking of just the value of the company’s equity here. By ‘value of the company’, we mean the market value of the company’s

assets, not just the value of the shareholders’ residual claim. Note that Equation 13.1 assumes the company’s EBIT is a perpetuity.

Our company’s cost of equity is

15%, but we can borrow money

at 7%. If we need to raise money

to fund a new investment, should

we borrow money because it’s

cheaper?

thinking cap
question

LO 13.2

Proposition II

Asserts that if we hold the

required return on assets

(ra) and the required return

on debt (rd) constant, the

expected return on levered

equity (rl) increases with the

debt-to-equity ratio