Does Debt Policy Matter?: Principles of Corporate Finance

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.
Topics Covered
Financial Leverage in a Competitive Tax
Free Environment
Financial Risk and Expected Returns
The Weighted Average Cost of Capital
A Final Word on After Tax WACC
17-2
M&M (Debt Policy Doesnt 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.
17-3

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
17-4

Dollar Investment Dollar Return
.01VU
.01 Profits
Debt
Equity
Total
Dollar Investment
.01D L
Dollar Return
.01 Interest
.01E L
.01(D L E L )
.01VL
.01 (Profits - Interest)

.01 Profits
17-5

Dollar Investment
Dollar Return
.01E L
.01 ( Profits - interest)
.01(VL DL )
Dollar Investment
Borrowing
.01D L
Dollar Return
- .01 Interest
Equity
.01VU
.01 Profits
Total
.01(VU D L )
.01 ( Profits - Interest)
17-6
17-7
Example - Macbeth Spot Removers - All Equity Financed

Data
Number of shares
1,000
Price per share
$10
Market Value of Shares $ 10,000

Outcomes
A
Operating Income
$500 1,000 1,500 2,000
Earnings per share

Return on shares (%)
$.50
5%
1.00
10
1.50
15
2.00
20
Expected
outcome

Example
cont.
50% debt
Data
Number of shares
Price per share
Market Value of Shares
Market value of debt
500
$10
$ 5,000
$ 5,000
Outcomes
Operating Income
Interest
Equity earnings
Earnings per share
Return on shares (%)
A
$500
$500
$0
$0
0%
B
1,000
500
500
1
10
C
1,500
500
1,000
2
20
D
2,000
500
1,500
3
30
17-8
17-9

Example - Macbeths
- All Equity Financed

- Debt replicated by investors
Outcomes
A
Earnings on two shares
$1.00 2.00 3.00 4.00
LESS : Interest @ 10%
$1.00 1.00 1.00 1.00
Net earnings on investment
$0
1.00
2.00 3.00
Return on $10 investment (%)
0%
10
20
30
Borrowing and EPS at Macbeth
17-10
No Magic in Financial Leverage

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.
17-11
17-12
Proposition I and Macbeth

Macbeth continued
Expected earnings per share ($)

Price per share ($)
Expected return per share (%)
Cuttent Structure : Proposed Structure :

All Equity
Equal Debt and Equity
1.50
2.00
10
15
10
20
Leverage and Returns
17-13
expected operating income

Expected return on assets ra
market value of all securities
D
E
rA
rD
rE
DE
DE
M&M Proposition II
rE rA rA rD
D
E
Macbeth continued

rE rA
1500
.15
10,000
17-14
M&M Proposition II
rE rA rA rD
D
E
Macbeth continued

1500
.15
10,000
rE rA
5000
rE .15 .15 .10
5000
.20 or 20%
17-15
17-16
Leverage and Risk

Macbeth continued
Leverage increases the risk of Macbeth shares
All
Allequity
equity Earnings
Earningsper
pershare
share($)
($)
Return
Returnon
onshares
shares
50
50%
%debt
debt:: Earnings
Earningsper
pershare
share($)
($)
Return
Returnon
onshares
shares
Operating
Operating
$1,500
$1,500to
to
1.50
1.50
15%
15%
22
20%
20%
Income
Income
$500
$500
0.50
0.50
5%
5%
00
00
Change
Change
--$1.00
$1.00
--10%
10%
--$2.00
$2.00
--20%
20%

Market Value Balance Sheet example
Asset Value
40
Asset Value
rd = 7.5%
re = 15%
100
100
Debt (D)
Equity (E)
60
Firm Value (V)
100
D
E
rA rD
rE
DE
DE
40
60
rA .075
.15
12.75%
100
100
17-17

Market Value Balance Sheet example continued
What happens to Re when debt costs rise?
Asset Value
40
Asset Value
100
Debt (D)
100
Equity (E)
60
Firm Value (V)
100
rd = 7.5% changes to 7.875%

re = ??
40
60
.1275 .07875
re
100
100
re 16.0%
17-18
DD
EE
BBAA BBDD BBEE

VV
VV
DD
BBEE BBAA BBAA BBDD
VV
17-19
WACC
WACC is the traditional view of capital

structure, risk and return.
DD
EE
WACC
WACC rrAA rrDD rrEE
VV
VV
17-20
17-21
WACC
r
rE
rA = WACC
rD
D
V
M&M Proposition II
17-22
WACC (traditional view)
17-23
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.
DD
EE
WACC
WACC rrDD rrEE
VV
VV
Old Formula
17-24
After Tax WACC

Tax Adjusted Formula
E
D
WACC rD (1 Tc )
rE
V
V
17-25
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?
17-26
After Tax WACC

Example - Union Pacific - continued
MARKET VALUES
17-27
After Tax WACC

Debt ratio = (D/V) = 63/200= .315 or 31.5%
Equity ratio = (E/V) = 137/200 = .685 or 68.5%
E
D
WACC rD (1 Tc )
rE
V
V
17-28
After Tax WACC

E
D
WACC rD (1 Tc )
rE
V
V
WACC (1 .35) .078 .315 .099 .685

.084
8. 4%
17-29
Union Pacific WACC
17-30
After Tax WACC
17-31
Another Example - Kates Cafe

Kates Caf 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?
After Tax WACC

Another Example - Kates Cafe- continued
MARKET VALUES
17-32
After Tax WACC

Debt ratio = (D/V) = 7.6/22.6= .34 or 34%
Equity ratio = (E/V) = 15/22.6 = .66 or 66%
E
D
WACC rD (1 Tc )
rE
V
V
17-33
After Tax WACC

E
D
WACC rD (1 Tc )
rE
V
V
WACC .055 (1 .35) .34 .10 .66

.078
7.8%
17-34
Web Resources
Click to access web sites
Internet connection required
http://finance.yahoo.com
www.valuepro.net
17-35

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Chapter 17

Does Debt Policy

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

M&M (Debt Policy Doesnt Matter)

M&M (Debt Policy Doesnt Matter)

M&M (Debt Policy Doesnt Matter)

.01 (Profits - Interest)

M&M (Debt Policy Doesnt Matter)

.01 ( Profits - Interest)

M&M (Debt Policy Doesnt Matter)

Example - Macbeth Spot Removers - All Equity Financed

Price per share

Market Value of Shares $ 10,000

$500 1,000 1,500 2,000

Earnings per share

M&M (Debt Policy Doesnt Matter)

M&M (Debt Policy Doesnt Matter)

- All Equity Financed

Earnings on two shares

$1.00 2.00 3.00 4.00

LESS : Interest @ 10%

$1.00 1.00 1.00 1.00

Net earnings on investment

Return on $10 investment (%)

Borrowing and EPS at Macbeth

No Magic in Financial Leverage

Proposition I and Macbeth

Expected earnings per share ($)

Cuttent Structure : Proposed Structure :

Leverage and Returns

expected operating income

expected operating income

expected operating income

Leverage and Risk

Leverage and Returns

Firm Value (V)

Leverage and Returns

Firm Value (V)

rd = 7.5% changes to 7.875%

Leverage and Returns

BBAA BBDD BBEE

WACC is the traditional view of capital

WACC (traditional view)

After Tax WACC

After Tax WACC

After Tax WACC

After Tax WACC

After Tax WACC

After Tax WACC

WACC (1 .35) .078 .315 .099 .685

Union Pacific WACC

After Tax WACC

Another Example - Kates Cafe

After Tax WACC

After Tax WACC

After Tax WACC

WACC .055 (1 .35) .34 .10 .66

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