Example:Homemade Leverage and ROE Current Capital Structure Proposed Capital Structure Investor borrows $2,000 Investor buys $1,000 worth and uses $2,000 of his own of stock(50 shares)and to buy 200 shares of stock $1,000 worth of Trans Am 口Payoffs: bonds paying 10%. Recession:200(1.25)-.1(2,000)= Payoffs: $50 Recession:50(.50)+.1(1,000)= Expected:200(2.50)-.1(2,000)= $125 $300 Expected:50(3.00)+.1(1,000)= Expansion:200(3.75)-.1(2,000)= $250 $550 Expansion:50(5.50)+.1(1,000)= Mirrors the payoffs from $375 purchasing 100 shares from Mirrors the payoffs from the firm under the proposed purchasing 100 shares capital structure under the current capital structure 10
10 Example: Homemade Leverage and ROE n Current Capital Structure q Investor borrows $2,000 and uses $2,000 of his own to buy 200 shares of stock q Payoffs: n Recession: 200(1.25) - .1(2,000) = $50 n Expected: 200(2.50) - .1(2,000) = $300 n Expansion: 200(3.75) - .1(2,000) = $550 q Mirrors the payoffs from purchasing 100 shares from the firm under the proposed capital structure n Proposed Capital Structure q Investor buys $1,000 worth of stock (50 shares) and $1,000 worth of Trans Am bonds paying 10%. q Payoffs: n Recession: 50(.50) + .1(1,000) = $125 n Expected: 50(3.00) + .1(1,000) = $250 n Expansion: 50(5.50) + .1(1,000) = $375 q Mirrors the payoffs from purchasing 100 shares under the current capital structure
Capital Structure Theory Modigliani and Miller Theory of Capital Structure Proposition I-firm value Proposition Il -WACC The value of the firm is determined by the cash flows to the firm and the risk of the firm's assets Changing firm value Change the risk of the cash flows Change the cash flows 11
11 Capital Structure Theory n Modigliani and Miller Theory of Capital Structure q Proposition I – firm value q Proposition II – WACC n The value of the firm is determined by the cash flows to the firm and the risk of the firm’s assets n Changing firm value q Change the risk of the cash flows q Change the cash flows
Capital Structure Theory Under Three Special Cases Case I-Assumptions No corporate or personal taxes No bankruptcy costs Case ll-Assumptions Corporate taxes,but no personal taxes No bankruptcy costs Case lll-Assumptions Corporate taxes,but no personal taxes Bankruptcy costs 12
12 Capital Structure Theory Under Three Special Cases n Case I – Assumptions q No corporate or personal taxes q No bankruptcy costs n Case II – Assumptions q Corporate taxes, but no personal taxes q No bankruptcy costs n Case III – Assumptions q Corporate taxes, but no personal taxes q Bankruptcy costs
Case I-Propositions I and II Proposition I The value of the firm is NOT affected by changes in the capital structure The cash flows of the firm do not change; therefore,value doesn't change Proposition Il The WACC of the firm is NOT affected by capital structure 13
13 Case I – Propositions I and II n Proposition I q The value of the firm is NOT affected by changes in the capital structure q The cash flows of the firm do not change; therefore, value doesn’t change n Proposition II q The WACC of the firm is NOT affected by capital structure