New on FinoLib · Volume II: Capital Markets
I have added a new article to FinoLib, my finance education website: Comparable Company Analysis (Comps) and Modigliani-Miller, part of Volume II: Capital Markets. This page gives you the core of the topic in expert but plain language; the full article goes much deeper.
1.6 Capital Structure & Modigliani-Miller
The idea in plain words
Two economists, Modigliani and Miller, proved in 1958 that in a perfect world a company’s value does not depend on how it splits its funding between debt and equity. Cheaper debt is exactly canceled by owners demanding more return as the company gets riskier. It is like cutting a pizza: slicing it differently doesn’t make the pizza bigger. In the real world the split matters only through frictions. Debt interest saves tax, but too much debt raises the expected cost of going bust.
Key points
■Proposition II: r_E = r_A + (D/E) × (r_A − r_D); $400m of 6% debt on a $1,000m firm lifts the cost of equity from 10% to 12.67% and leaves WACC at 10%.
■With the 21% federal tax, permanent debt adds at most t × D: $84m on $400m of debt.
■IRC §163(j) caps deductible interest at 30% of adjusted taxable income, roughly EBITDA for tax years beginning after 2024.
A closer look
Capital structure is the mix of debt and equity a company chooses to finance itself. In 1958, economists Franco Modigliani and Merton Miller proved a deliberately provocative result: in a simplified world with no taxes, no bankruptcy costs, and perfect information, a company’s capital structure has no effect at all on its total value — the pie can be sliced between debt and equity in any proportion, but the size of the pie stays the same.
Decision rule
When leverage changes (a recapitalization, an LBO), never hold the cost of equity constant: apply Proposition II or re-lever beta, then recompute WACC. Credit permanent debt with at most t × D of value (21 cents per dollar federally), nothing on interest above 30% of EBITDA, and nothing if the company lacks taxable income. Stop borrowing when expected distress costs rise faster than the shield. Ignore this rule for banks and insurers, whose capital regulators set.
The costliest mistake
Adding “cheap” debt without repricing equity. With $400 million of debt the firm above is worth $874 million: equity of $474 million costs 10% + (400 ÷ 474) × 0.79 × 4% = 12.67%, so WACC = (474 ÷ 874) × 12.67% + (400 ÷ 874) × 6% × 0.79 = 9.04%, and $79m ÷ 0.0904 = $874 million. Leave equity at 10% and keep the no-tax example’s 60/40 weights, and WACC becomes 0.60 × 10% + 0.40 × 6% × 0.79 = 7.90%, giving $79m ÷ 0.0790 = $1,000.5 million.
1.7 Comparable Company Analysis (“Comps”)
The idea in plain words
Comparable company analysis values a business the way you might price a house: by looking at what similar ones sell for. You pick a group of similar listed companies, see what multiple of earnings the market pays for them, and apply that multiple to your target’s own earnings. Use the middle value and the typical range of the group, and measure every company’s earnings in the same way so you compare like with like.
Key points
■Ridgeline’s peers trade at 7.8× to 9.9× EBITDA; the median 8.85× on $150m of EBITDA gives $20.55 a share after $300m of net debt.
■EV multiples survive differences in leverage; P/E does not (12.7× versus 9.0× for the same business).
■Put every peer on the same period (LTM or NTM) and the same accounting; IFRS 16 lifts EBITDA relative to US GAAP.
Decision rule
Use the peer median and the 25th-to-75th percentile range, not the mean, unless every peer is close to the median. If peers’ net debt to EBITDA differs by more than about one turn, value on EV multiples only. If the target’s growth or margin sits outside the peers’ range, do not apply the median: position the target inside the range by regressing peers’ multiples on growth or margin, or move to a DCF.
The costliest mistake
Applying peers’ multiples, computed on reported EBITDA, to the target’s “adjusted” EBITDA. Suppose Ridgeline’s $150 million includes $15 million of restructuring costs added back every year for three years. They recur, so they are costs. At 8.85×, the add-back inflates EV by $15m × 8.85 = $132.75 million, or $132.75m ÷ 50m = $2.66 a share: 12.9% on the $20.55 median value. Rebuild every company’s EBITDA, target included, from the same reported line, and treat add-backs that recur for two years running as recurring costs.
What the full article covers
In the full article I take you through these sections:
■1.6 Capital Structure & Modigliani-Miller
■1.7 Comparable Company Analysis (“Comps”)
It includes worked examples, a look under the hood at the mechanics, a clear decision rule, the one mistake that costs people the most, a recap, a reveal-on-click quiz and the official sources behind every figure.
Volume II: Capital Markets
Read the full article on FinoLib
The complete article, Comparable Company Analysis (Comps) and Modigliani-Miller, with every worked example, diagram, quiz and source, is free to read in Volume II, Capital Markets on finolib.com.
Explore the Finance Education Series: Vol. II — Capital Markets · Vol. I — Global Economy · Vol. III — Finance Encyclopedia · Vol. IV — Finance Careers · Vol. V — Personal Finance