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A
Ch 15 Mini Case

G
3/3/2003

Chapter 15. Mini Case

Situation
David Lyons, the CEO of Lyons Solar Technologies, is concerned about his firm's level of debt financing. The company uses short-term debt to
finance its temporary working capital needs, but it does not use any permanent (long-term) debt. Other solar technology companies average
about 30 percent debt, and Mr. Lyons wonders why the difference occurs, and what its effects are on stock prices. To gain some insights into
the matter, he poses the following questions to you, his recently hired assistant.

a. Business Week recently ran an article on companies' debt policies, and the names Modigliani and Miller (MM) were mentioned several times
as leading researchers on the theory of capital structure. Briefly, who are MM, and what assumptions are embedded in the MM and Miller
models? Answer: See Chapter 15 Mini Case Show

Modigliani and Miller without Taxes

Franco Modigliani and Merton Miller developed a model to examine the impact of debt on firm value. In this first version it is assumed that
taxes are zero.
1. Assume that Firms U and L are in the same risk class, and that both have EBIT = $500,000. Firm U uses no debt financing, and its cost of
equity is rsU = 14%. Firm L has $1 million of debt outstanding at a cost of rd = 8%. There are no taxes. Assume that the MM assumptions
hold, and then:
a. Find V, S, rs, and WACC for Firms U and L.
Proposition I.
1. The weighted average cost of capital is independent of the firm's capital structure.
2. The WACC of a firm with debt is equal to the unlevered cost of equity.
Proposition II.
The cost of equity, rsL = rsU + Risk premium = rsU + (rsU -rd)(D/S)

Input Data

Firm U
No Debt
$500,000
$0
na
14%

Firm L
Some Debt
$500,000
$1,000,000
8.0%
na

Value
of Firm

$3,571,429

$3,571,429

Value of Equity

$3,571,429

$2,571,429

EBIT
Debt
rd
rs

Value of Firm = (EBIT/rs)

rsL =

rsU

(rsU-rd)

(D/S)

rsL =

14%

6.00%

0.39

rsL =

16.33%

WACC =

wd*rd

wce*rs

(D/V)*rd

(S/V)*rs

WACC =

2.24%

11.8%

WACC =

14.00%

S
$3.50
$3.00
$2.50
$2.00
$1.50

D/V
0.00%
14.29%
28.57%
42.86%
57.14%

rd

rs

8.00%
8.00%
8.00%
8.00%
8.00%

14.00%
15.00%
16.40%
18.50%
22.00%

WACC
14.00%
14.00%
14.00%
14.00%
14.00%

MM without Taxes
D
0.0
0.5
1.0
1.5
2.0

V
$3.50
$3.50
$3.50
$3.50
$3.50

(2.) Graph (a) the relationships between capital costs and leverage as measured by D/V, and (b) the relationship between value and D.

Without Taxes

25.00%
20.00%
Cost of Capital

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15.00%

rs
WACC
rd

10.00%
5.00%
0.00%
0.00%

20.00%
40.00%
Debt/Value Ratio

60.00%

c. Using the data given in Part b, but now assuming that Firms L and U are both subject to a 40 percent corporate tax rate, repeat the analysis
called for in b(1) and b(2) under the MM with-tax model

Modigliani and Miller with CorporateTaxes

The MM results are different once corporate taxes are added in.
Proposition I ( with corporate taxes)
Value of levered firm is the unlevered value plus the debt tax shield: VL = VU + TD
Proposition II (with corporate taxes)
The cost of equity to a levered firm is the unlevered cost of equity plus a risk premium:
rsL = rsU + (rsU - rd)(1-T)(D/S)

Input Data
EBIT
Debt
rd
rs
Tax Rate
Value
of Equity

Firm U
No Debt
$500,000
$0
na
14.00%
0%

Firm L
Some Debt
$500,000
$1,000,000
8.0%
16.33%
0%

40% Tax Rate

No Debt
$500,000
$0
8.0%
14.00%
40%

40% Tax Rate

Some Debt
$500,000
$1,000,000
8.0%
16.33%
40%

$3,571,429

$2,571,429

$2,142,857

$1,542,857

rsL = rsU + (rsU - rd)(1-T)(D/S)

Value of Stock = (EBIT - rdD)(1 - T)/rS

Total Market
Value of Firm
WACC

$0

$0

$0

$400,000

$3,571,429
14.00%

$3,571,429
14.00%

$2,142,857
14.00%

$2,542,857
11.80%

Value of Tax Shield = T x Debt

Value of Firm = Value of Unlevered Firm +T x Debt

WACC = (D/V)rd(1-T) + (S/V)rs

Effects of Leverage: MM Models

MM with Corporate Taxes

Tc =
40.00%
D
0.0
0.5
1.0
1.5
2.0
2.5
3.0
3.5

V
$2.14
$2.34
$2.54
$2.74
$2.94
$3.14
$3.34
$3.54

S
$2.14
$1.84
$1.54
$1.24
$0.94
$0.64
$0.34
$0.04

D/V
0.00%
21.37%
39.37%
54.74%
68.03%
79.62%
89.82%
98.87%

rd

rd x (1-T)

rs

8.00%
8.00%
8.00%
8.00%
8.00%
8.00%
8.00%
8.00%

4.80%
4.80%
4.80%
4.80%
4.80%
4.80%
4.80%
4.80%

14.00%
14.98%
16.34%
18.35%
21.66%
28.06%
45.76%
329.00%

With Taxes
50.00%
45.00%
40.00%
35.00%
30.00%
25.00%
20.00%
15.00%
10.00%
5.00%
0.00%
0.00%

V-No Taxes
$3.50
$3.50
$3.50
$3.50
$3.50

WACC
14.00%
12.80%
11.80%
10.93%
10.19%
9.54%
8.97%
8.46%

rs
WACC
rd x (1-T)

20.00%

V-Taxes
$3.50
$3.70
$3.90
$4.10
$4.30

40.00% 60.00%
Debt/Value Ratio

80.00% 100.00%

Relationship Between Value and Debt

Value of Firm

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A
Value of Tax
Shield

Cost of Capital

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$5.00
$4.50
$4.00
$3.50
$3.00
$2.50
$2.00
$1.50
$1.00
$0.50
$0.00

Without Taxes
With Taxes

Debt

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d. Now suppose investors are subject to the following tax rates: Td = 30% and Ts = 12%.
(1.) What is the gain from leverage according to the Miller model?
(2.) How does this gain compare to the gain in the MM model with corporate taxes?
(3.) What does the Miller model imply about the effect of corporate debt on the value of the firm, that is, how do personal taxes affect the
situation? Answer: See Chapter 15 Mini Case Show

e. What capital structure policy recommendations do the three theories (MM without taxes, MM with corporate taxes, and Miller) suggest to
financial managers? Empirically, do firms appear to follow any one of these guidelines? Answer: See Chapter 15 Mini Case Show

f. How is the analysis in part c different if firms U and L are growing? Assume that both firms are growing at a rate of 7 percent and that 10
percent of EBIT must be reinvested in net operating assets to support growth.
Relevant information from part c.
EBIT
Tax rate
Unlevered cost of equity
Cost of debt

500,000
40%
14% = WACC if there is no debt
8%

Additional information
Required reinvestment
growth rate
FCF Calculation
NOPAT
NOPAT
NOPAT

50,000
7%

=
=
=

EBIT
500,000
300,000

x
x

FCF--7% growth
FCF--7% growth
FCF--7% growth

=
=
=

NOPAT
300,000
250,000

FCF -- 0% growth
FCF -- 0% growth

=
=

NOPAT
300,000

Data for
Lyons
exp. FCF
Debt
rd
rsU
Tax Rate
growth
Value of
Unlev. Firm
Value of
Tax Shield
Total Value
Of Firm
Value of

(1-T)
60%

Firm U
Firm U
Firm L
Firm L
40% Tax Rate
40% Tax Rate
40% Tax Rate
40% Tax Rate
zero Debt
zero Debt
some Debt
some Debt
and no growth and 7% growth and no growth
and 7% growth
$
300,000 $
250,000 $
300,000 $
250,000
$
### $
1,000,000 $
1,000,000
8.0%
8.0%
8.0%
8.0%
14.00%
14.00%
14.00%
14.00%
40%
40%
40%
40%
0%
7%
0%
7%
$2,142,857

$3,571,429

$2,142,857

$3,571,429

$0

$0

$228,571

$457,143

$2,142,857

$3,571,429

$2,371,429

$4,028,571

Required net reinvestment at 7% growth

50,000

WACC = rsU if the firm is unlevered

Value of Unlevered firm = FCF/(WACC - g)

Value of Tax Shield = (rd T D)/( rU - g)

Value of Firm = Value of Unlevered Firm + Value of

Cost of capital

A
B
C
D
E
F
G
H
I
$2,142,857
$3,571,429
$1,371,429
$3,028,571
Value of Equity = Total Value of Firm - Value of Deb
232 Equity
rsL = rsU + (rsU - rd)(D/S)
14.000%
14.000%
18.375%
15.981%
233 rsL
WACC = (D/V)rd(1-T) + (S/V)rs
14.000%
14.000%
12.651%
13.206%
234 WACC
0.000%
0.000%
42.169%
24.823%
235 D/V
236
237
238 This column is the same as the
This column will NOT be the same as the "40% tax
239 "40% tax rate no debt" column
rate, some debt" column from part c because we are
240 from part c.
discounting the tax shield at rsU instead of rd.
241
242
growth = 7.00%
243 Extension to MM with growth: rTS = rsU.
40.00%
244 T =
rsL
D
V
S
D/V
Tax shield
WACC
245
$4,028,571
$3,028,571
24.823%
$457,143
15.981%
13.206%
246
3,571,429
3,571,429
0.00%
14.00%
14.00%
247
500,000
3,800,000
3,300,000
13.16%
228,571
14.91%
13.58%
248
1,000,000
4,028,571
3,028,571
24.82%
457,143
15.98%
13.21%
249
1,500,000
4,257,143
2,757,143
35.23%
685,714
17.26%
12.87%
250
2,000,000
4,485,714
2,485,714
44.59%
914,286
18.83%
12.57%
251
2,500,000
4,714,286
2,214,286
53.03%
1,142,857
20.77%
12.30%
252
3,000,000
4,942,857
1,942,857
60.69%
1,371,429
23.26%
12.06%
253
3,500,000
5,171,429
1,671,429
67.68%
1,600,000
26.56%
11.83%
254
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257
Cost of Capital with growth
258
30.00%
259
260
25.00%
261
262
20.00%
263
rsL
264
15.00%
WACC
265
266
10.00%
267
5.00%
268
269
0.00%
270
0.00% 10.00% 20.00% 30.00% 40.00% 50.00% 60.00% 70.00% 80.00%
271
D/V
272
273
274 Things to note:
275 1. The gain from the tax shield will be lower using the Extension to MM's model than under MM
276 because this Extension discounts the interest tax shield at the unlevered cost of equity, which is
277 larger than the cost of debt. The MM model discounts the tax shield at the cost of debt.
278 2. The gain from debt is larger with growth than without growth.
279 3. The value of the firm, whether levered or not, will be larger with growth, provided ROIC is greater
280 than WACC. See Chapter 10 for a discussion. Although we don't show it here, ROIC is greater
281 than WACC, so the value of the firm increases with growth.
282
283 The increase in the firm's value as a result of $1,000,000 in debt over its unlevered value is:
284
Increase in value =
12.80% of the unlevered value
285
286
287 MM versus Extension rsL and WACC
288
8.0%
289 rd

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298

rsU

Tax Rate
D/V
D/S
MM rsL
MM WACC
Extension rsL
Extension WAC

299

MM rsL
D/V
0%
10%
20%
30%
40%
50%
60%
70%
80%

Extension rsL Extension WACC

MM WACC
11.20% 20.00%
12.40%
14.00%
14.00%
14.00%
13.44%
14.67%
13.68%
12.88%
15.50%
13.36%
12.32%
16.57%
13.04%
11.76%
18.00%
12.72%
11.20%
20.00%
12.40%
10.64%
23.00%
12.08%
10.08%
28.00%
11.76%
9.52%
38.00%
11.44%

17.60%
14.00%
14.40%
14.90%
15.54%
16.40%
17.60%
19.40%
22.40%
28.40%

Costs of capital for MM and Extension

Cost of Capital

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C
14.00%
40%
50%
1
17.60%
11.20%
20.00%
12.40%

40.00%
35.00%
30.00%
25.00%
20.00%
15.00%
10.00%
5.00%
0.00%

MM rsL
MM WACC
Extension rsL
Extension WACC

0% 10% 20% 30% 40% 50% 60% 70% 80% 90%

D/V

g. What if L's debt is risky? For the purpose of this example, assume that the value of L's operations if
$4 million--which is the value of its debt plus equity. Assume also that ists debt consists of 1-year zero
coupon bonds with a face value of $2 million. Finally, assume that L's volatility is 0.60 (sigma = 0.60) and
that the risk free rate is 6 percent.
If L's debt is risky, then its equity is like a call option and can be valued with the Black-Scholes Option
Pricing Model (BSOPM). See Chapter 13 for details of the BSOPM.
Black-Scholes Option Pricing Model
Total Value of Firm
Face Value of Debt
Risk Free rate
Maturity of debt (years)
Standard Dev.
d1
d2
N(d1)

4.00
2.00
0.06
1.00
0.60
1.5552
0.9552
0.9401

Analogous to the stock price from the BSOPM

Analogous to the exercise price
Analogous to time to expiration of option
This is the standard dev. of the total value of the firm, not just the stock.

N(d2)

Call Price = Equity Value

Debt Value

Debt yield
Debt yield

=
=
=

0.8303
2.1964

Total Value
4.00
$
1.8036

=
=

Equity Value
2.1964 (all in millions)

(Face Value /Market Value)(1/N)-1

10.888%

The value of L's equity must be $2.20 million. The value of its debt must be what is left over: $1.80 million.
This gives a yield of 10.88% for the debt.

h. What is the value of L's stock for volatilities between 0.20 and 0.95? What incentives might the
manager of L have if she understands this relationship? What might debtholders do in response?
Answer: See below and the Chapter 15 Mini Case Show.
Value of Stock and Debt for Different Volatilities
Equity
Debt
Debt yield
Volatility $
2.20 $
1.80
10.888%
0.20
2.12
1.88
6.18%
0.25
2.12
1.88
6.20%
0.30
2.12
1.88
6.27%
0.35
2.12
1.88
6.48%
0.40
2.13
1.87
6.89%
0.45
2.14
1.86
7.53%
0.50
2.16
1.84
8.41%
0.55
2.17
1.83
9.54%
0.60
2.20
1.80
10.89%
0.65
2.22
1.78
12.46%
0.70
2.25
1.75
14.24%
0.75
2.28
1.72
16.23%
0.80
2.31
1.69
18.40%
0.85
2.34
1.66
20.77%
0.90
2.38
1.62
23.33%
0.95
2.41
1.59
26.08%

Values of Debt and Equity for Different Volatilities

3.00
2.50
Value (millions)

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2.00
Equity
Debt

1.50
1.00
0.50
0.00
0.10

0.20

0.30

0.40

0.50

0.60

Volatility (sigma)

0.70

0.80

0.90

1.00

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rdD)(1 -115
T)/rS

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= FCF/(WACC
- g)
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T D)/( r228
- g)
U

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230Firm + Value of Tax Shield
231

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J
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