You are Mariana Pestana-Vasconcelos, CFO of Lusitana Beverages, a beverage company listed in Lisbon with very stable cash flows and zero debt. An activist fund has taken a stake with a simple idea: take on debt and buy back shares. "Your EPS would soar," they say. They're right about EPS. The question is whether they're right about value.
The situation
Lusitana earns €200M a year, has 100M shares outstanding (EPS €2.00), trades at €30 (P/E 15), and has book equity of €1,500M. The activist proposes a leveraged recapitalization: issue up to €600M in debt at 5% and use it to buy back shares. Since the earnings yield (1/P/E = 6.7%) exceeds the after-tax cost of debt (~4%), EPS rises. So does ROE.
Here's the trap that Modigliani and Miller taught. In a world without taxes, re-levering doesn't change the value of the firm: it only redistributes risk between shareholders and creditors, and the P/E falls to offset the higher EPS. The real value a recap creates comes only from the tax shield of the new debt —and trade-off theory says that value has a ceiling, where the cost of distress and the loss of flexibility start eating it away.