Chap017

Chapter 17Principles of

Corporate FinanceTenth Edition

Does Debt Policy Matter?

Slides by

Matthew Will

McGraw-Hill/Irwin Copyright © 2011 by the McGraw-Hill Companies, Inc. All rights reserved.

17-2

Topics Covered

Financial Leverage in a Competitive Tax Free Environment

Financial Risk and Expected ReturnsThe Weighted Average Cost of CapitalA Final Word on After Tax WACC

17-3

M&M (Debt Policy Doesn’t Matter)

Modigliani & Miller– When there are no taxes and capital markets

function well, it makes no difference whether the firm borrows or individual shareholders borrow. Therefore, the market value of a company does not depend on its capital structure.

17-4

M&M (Debt Policy Doesn’t Matter)

Assumptions

By issuing 1 security rather than 2, company diminishes investor choice. This does not reduce value if:– Investors do not need choice, OR– There are sufficient alternative securities

Capital structure does not affect cash flows e.g...– No taxes– No bankruptcy costs– No effect on management incentives

17-5

M&M (Debt Policy Doesn’t Matter)

Profits01.01V.

urnDollar RetInvestmentDollar

U

L

LL

L

L

01V.

Profits01.)E01(D.Total

Interest)-Profits(01.01E.Equity

Interest.0101D.Debt

ReturnDollar InvestmentDollar

17-6

M&M (Debt Policy Doesn’t Matter)

).01(V

interest)-Profits(01.01E.

urnDollar RetInvestmentDollar

LL

L

D

Interest)-Profits(01.)D01(V.Total

Profits01.01V.Equity

Interest.01-01D.Borrowing

urnDollar RetInvestmentDollar

LU

U

L

17-7

Example - Macbeth Spot Removers - All Equity Financed

201510% 5(%) shares on Return

2.001.501.00$.50shareper Earnings

2,0001,5001,000$500Income Operating

D C BA

Outcomes

10,000 $Shares of ValueMarket

$10shareper Price

1,000shares ofNumber

Data

M&M (Debt Policy Doesn’t Matter)

Expected outcome

17-8

3020100%(%) shares on Return

321$0shareper Earnings

500,11,000500$0earningsEquity

500500500$500Interest

000,21,5001,000$500Income Operating

CBA

Outcomes

5,000 $debt of ueMarket val

5,000 $Shares of ValueMarket

$10shareper Price

500shares ofNumber

Data

D

Example

cont.

50% debt

M&M (Debt Policy Doesn’t Matter)

17-9

3020100%(%) investment$10 on Return

3.002.001.000 $investment on earningsNet

1.001.001.00$1.0010% @Interest :LESS

4.003.002.00$1.00shares twoon Earnings

DCBA

Outcomes

Example - Macbeth’s - All Equity Financed

- Debt replicated by investors

M&M (Debt Policy Doesn’t Matter)

17-10

Borrowing and EPS at Macbeth

17-11

MM'S PROPOSITION I

If capital markets are doing their job, firms cannot increase value by tinkering with capital structure.

V is independent of the debt ratio.

AN EVERYDAY ANALOGY

It should cost no more to assemble a chicken than to buy one whole.

No Magic in Financial Leverage

17-12

Proposition I and Macbeth

2015(%) shareper return Expected

1010($) shareper Price

2.001.50($) shareper earnings Expected Equityand Debt Equal

:Structure Proposed

EquityAll

:StructureCuttent

Macbeth continued

17-13

Leverage and Returns

securities all of uemarket val

income operating expectedr assets on return Expected a

EDA r

ED

Er

ED

Dr

17-14

M&M Proposition II

15.000,10

1500securities all of uemarket val

income operating expectedr r AE

E

Drrrr DAAE

Macbeth continued

17-15

M&M Proposition II

E

Drrrr DAAE

15.000,10

1500securities all of uemarket val

income operating expectedr r AE

20%or 20.5000

500010.15.15.

Er

Macbeth continued

17-16

Leverage and Risk

20%-020%shareson Return

$2.00-02($) shareper Earnings:debt % 50

10%-5%15%shareson Return

$1.00-0.501.50($) shareper Earningsequity All

Change$500

Income

to$1,500

Operating

20%-020%shareson Return

$2.00-02($) shareper Earnings:debt % 50

10%-5%15%shareson Return

$1.00-0.501.50($) shareper Earningsequity All

Change$500

Income

to$1,500

Operating

Macbeth continued

Leverage increases the risk of Macbeth shares

17-17

Leverage and Returns

%75.12100

6015.

100

40075.

A

EDA

r

ED

Er

ED

Drr

Asset Value 100 Debt (D)40

Equity (E) 60

Asset Value 100 Firm Value (V) 100

rd = 7.5%

re = 15%

Market Value Balance Sheet example

17-18

Leverage and Returns

%0.16

100

60

100

4007875.1275.

e

e

r

r

Asset Value 100 Debt (D)40

Equity (E) 60

Asset Value 100 Firm Value (V) 100

rd = 7.5% changes to 7.875%

re = ??

Market Value Balance Sheet example – continued

What happens to Re when debt costs rise?

17-19

Leverage and Returns

V

EB

V

DBB EDA

V

EB

V

DBB EDA

DAAE BBV

DBB DAAE BB

V

DBB

17-20

WACC

V

Er

V

DrrWACC EDA

V

Er

V

DrrWACC EDA

WACC is the traditional view of capital structure, risk and return.

17-21

r

DV

rD

rE

rA = WACC

WACC

17-22

M&M Proposition II

17-23

WACC (traditional view)

17-24

After Tax WACC

The tax benefit from interest expense deductibility must be included in the cost of funds.

This tax benefit reduces the effective cost of debt by a factor of the marginal tax rate.

V

Er

V

DrWACC ED

V

Er

V

DrWACC ED

Old Formula

17-25

After Tax WACC

V

Er

V

DTcrWACC ED )1(

Tax Adjusted Formula

17-26

After Tax WACC

Example - Union Pacific

The firm has a marginal tax rate of 35%. The cost of equity is 9.9% and the pretax cost of debt is 7.8%. Given the book and market value balance sheets, what is the tax adjusted WACC?

17-27

After Tax WACC

Example - Union Pacific - continued

Balance Sheet (Market Value, billions)Assets 200 63 Debt

137 EquityTotal assets 200 200 Total liabilities

Balance Sheet (Market Value, billions)Assets 200 63 Debt

137 EquityTotal assets 200 200 Total liabilities

MARKET VALUES

17-28

After Tax WACC

Example - Union Pacific - continued

V

Er

V

DTcrWACC ED )1(

Debt ratio = (D/V) = 63/200= .315 or 31.5%

Equity ratio = (E/V) = 137/200 = .685 or 68.5%

17-29

After Tax WACC

Example - Union Pacific - continued

V

Er

V

DTcrWACC ED )1(

%4.8

084.

685.099.315.078.)35.1(

WACC

17-30

Union Pacific WACC

17-31

After Tax WACC

Another Example - Kate’s Cafe

Kate’s Café has a marginal tax rate of 35%. The cost of equity is 10.0% and the pretax cost of debt is 5.5%. Given the book and market value balance sheets, what is the tax adjusted WACC?

17-32

After Tax WACC

Another Example - Kate’s Cafe- continued

Balance Sheet (Market Value, billions)Assets 22.6 7.6 Debt

15 EquityTotal assets 22.6 22.6 Total liabilities

Balance Sheet (Market Value, billions)Assets 22.6 7.6 Debt

15 EquityTotal assets 22.6 22.6 Total liabilities

MARKET VALUES

17-33

After Tax WACC

Another Example - Kate’s Cafe- continued

V

Er

V

DTcrWACC ED )1(

Debt ratio = (D/V) = 7.6/22.6= .34 or 34%

Equity ratio = (E/V) = 15/22.6 = .66 or 66%

17-34

After Tax WACC

Another Example - Kate’s Cafe- continued

V

Er

V

DTcrWACC ED )1(

%8.7

078.

66.10.34.)35.1(055.

WACC

17-35

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