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The value of a firm from two angles
Assets
Value of cash flows
from firm’s real
assets and operations
Value of Firm
LO1
Liabilities and Stockholder’s
Equity
Market value of debt
Market value of equity
Value of Firm
© 2012 McGraw-Hill Ryerson Limited
Chapter 16 -1
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
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A firm’s capital structure is the mix of debt
and equity its financial managers choose
Does the choice of capital structure affect the value
of a firm
Modigliani and Miller (MM)
◦ When there are no taxes and well functioning capital
markets exist, the market value of a company does not
depend on its capital structure
◦ In other words, managers cannot increase firm value by
changing the mix of securities used to finance the company
LO1
© 2012 McGraw-Hill Ryerson Limited
Chapter 16 -2
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MM Assumptions:
◦ Capital markets have to be “well functioning”
 Investors can borrow/lend on the same terms as firms
 Capital markets are efficient
◦ There are no taxes or costs of financial distress

LO1
Example: in the next few slides, it is shown how the
River Cruise company is operating now and how can it
change its structure. At the end, it is shown that
whatever it achieves by changing its structure, can be
replicated by the shareholders themselves. MM called it
the ‘home-made leverage’.
© 2012 McGraw-Hill Ryerson Limited
Chapter 16 -3
The River Cruise example: Current Structure
Number of shares
100,000
Price per share
$10
Market Value of Shares $ 1 million
Outcome
Operating Income
Earnings per share
Return on Shares
LO1
Value of firm = $1 mill
State of the Economy
Slump
$75,000
$.75
7.5%
Expected
125,000
1.25
12.5%
Boom
175,000
1.75
17.5%
© 2012 McGraw-Hill Ryerson Limited
Chapter 16 -4

The River Cruise example: Proposed Structure
Issue $500,000 of debt with a 10% coupon and use the funds
to repurchase 50,000 shares at $10 apiece
Number of shares
Price per share
50,000
$10
Market Value of Shares
500,000
Market val ue of debt
500,000
Value of firm = D+E= $500,000 + $500,000 = $1 mill
LO1
© 2012 McGraw-Hill Ryerson Limited
Chapter 16 -5
Earnings and returns per share with debt
State of the Economy
Operating
Income
Interest
Equity
earnings
Earnings
per share
Return on shares
LO1
Slump
Expected
Boom
$75,000
125,000
175,000
$50,000
50,000
50,000
$25,000
75,000
125,000
$.50
1.50
2.50
5%
15%
25%
© 2012 McGraw-Hill Ryerson Limited
Chapter 16 -6
If the firm did not borrow, but the shareholders
borrowed $10 to buy one more share. This would make
them have a debt of 50%, the same as that of the
proposed firm structure.
Outcome
State of the Economy
Slump
Expected
Boom
Earnings on two shares
$1.50
2.50
3.50
LESS : Interest @ 10%
$1.00
1.00
1.00
Net earnings on investment
$.50
1.50
2.50
Return on $10 investment
5%
15%
25%
LO1
© 2012 McGraw-Hill Ryerson Limited
Chapter 16 -7
How borrowing affects risk and return
All Equity Financing
Firm Value:
$1 million
After Restructuring
Debt:
$500,000
Equity:
$500,000
Even though the value of the firm remains unchanged,
shareholders of the levered firm face a higher risk and
therefore demand a higher return
LO1
© 2012 McGraw-Hill Ryerson Limited
Chapter 16 -8

Restructuring does not affect operating income
◦ The operating risk, or business risk, of the firm is
unchanged
◦ However, with more debt in the capital structure, the
EPS becomes more risky. The financial risk of the firm
increases.

MM’s Proposition II
◦ The required return on a firm’s equity increases as the
firm’s debt-equity ratio increases
D
requity  rassets   rassets  rdebt 
E
LO1
© 2012 McGraw-Hill Ryerson Limited
Chapter 16 -9
MM’s proposition II with constant rDebt
Note: rdebt need not be constant
LO1
© 2012 McGraw-Hill Ryerson Limited
Chapter 16 -10