Chapter 17 Principles of Corporate Finance Tenth Edition Does Debt Policy Matter? Slides by Matthew Will McGraw-Hill/Irwin Copyright © 2011 by the McGraw-Hill Companies, Inc. All rights reserved.
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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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