An enduring controversy within financial theory concerns the effect of financial leverage on the value and stock price of a company. Can a company affect its overall value by selecting an optimal financing mix (debt and equity)? The firms mix of debt and equity financing is called its capital structure. The essentials of the capital structure and the effect of financial policies on the value of the firm were pioneering work of Noble recipients Modigliani and Miller in 1958 and 1963.¹

The essential question is: Does debt financing create value? If so, how? If not, then why do so many financial mangers try to find the combination of securities that has greatest overall effect on the market value of the firm?

This short case presents a simple model of Modigliani-Miller theorem to highlight the advantage of debt financing and whether there is an optimal capital structure that maximizes the value of the firm. However, it ignores other market imperfections such as bankruptcy and agency problems among security holders that would affect the value of the firm.

Radstone, Inc., a prominent stone fabrication firm was formed 5 years ago to exploit a new continuous fabrication process. Radstone's founders, Jim Rad and Mick Rad, had been employed in the research department of a major integrated-stone fabrication company, but when that company decided against using the new process, they decided to strike out on their own. One advantage of the new process was that it required relatively little capital in comparison with the typical fabrication company, so they have been able to avoid issuing debt financing, and thus they own all of the shares. However, the company has now reached the stage where outside capital is necessary if the firm is to achieve its growth targets. Therefore, they have decided to leverage the company with swapping some of their shares with new debt.

Currently the company has value of $5 million with outstanding shares of 100,000. The company generates $1,538,461.5 in earnings before interest and taxes (EBIT) in perpetuity. The corporate tax rate is 35 percent and all earnings are paid as dividends. The company is considering the effect of $2 million and $2.5 million debt equity swap on its cost of capital and its value. The cost of debt is 10 percent and the cost of capital is currently 20 percent. Any investment in net working capital and capital expenditure is equal to its depreciation allowances. The corporate tax rate is 35 percent.

Table 1	Current	Debt	Debt
	Capital Structure	$2,000,000	$2,500,000
Pure Business Cash Flows:
EBIT
Taxes (@ 35%)
Net Income
+Depreciation
-Capital Exp.
-Change in net working capital
Free Cash Flow
Unlevered WACC
Value of Pure Business Flows:(FCF/Unlevered WACC)
Financing Cash Flows
Interest at 10%
Tax Reduction
Pretax Cost of Debt
Value of Financing Effect:
(Tax Reduction/Pretax Cost of Debt
Total Value (Sum of Values of Pure Business Flows and Financing effects

Table 2	Current	Debt	Debt
	Capital Structure
Book Value of Debt	$ -	$2,000,000	$2,500,000
Book Value of Equity	$5,000,000	$3,000,000	$2,500,000
V=D+E	$5,000,000	$5,000,000	$5,000,000
Market Value of Debt		$2,000,000	$2,500,000
Market Value of Equity
V=D+E
Pretax Cost of Debt	10.00%	10.00%	10.00%
After-Tax Cost of Debt 35%	6.50%	6.50%	6.50%
Market Value Weights of
Debt
Equity
Cost of Equity	20.00%
Weighted-Average Cost of Capital	20.00%
EBIT	$ 1,538,461.50	$ 1,538,461.50	$ 1,538,461.50
Taxes (@ 35%)
Net Income
+ Depreciation
-change in NWC
-Capital exp.
Free Cash Flow
Value of Firm (FCF/WACC)

Table 3	Current	Debt	Debt
	Capital Structure
Cash Flow to Debtholders (interest)
Pretax Cost of Debt
Value of Debt:(Interest/Rd)
Cash Flow to Shareholders:
EBIT
Interest
Pretax Profit
Taxes (@ 35%)
Net Income
+ Depreciation
- change in NWC
- Capital exp.
Cash Flow to Shareholders:
Cost of Equity
Value of Equity (FCFEquity/RE)
Value of Equity plus Value of Debt

Questions:

What is the value of the firm under each capital structure?

What is the cost of equity and weighted average cost of capital for each capital structure?

What is the value of tax shield under each level of debt financing?

Why does the value of firm change and specifically where do the changes occur?

As the firm levers up, how does the increase in value get apportioned between debtholders and stockholders?

What is the price per share under each capital structure?

Are the shareholders better or worse off? Explain