Does Debt Policy Matter?

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17- 1

Does Debt Policy


Matter?
17- 2

Capital Structure
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)

Dollar Investment Dollar Ret urn


.01VU .01  Profits

Dollar Investment Dollar Ret urn


Debt .01D L .01  Interest
Equity .01E L .01  ( Profits - Interest)
Total .01(D L  E L ) .01  Profits
 .01VL
17- 6

M&M (Debt Policy Doesn’t Matter)

Dollar Investment Dollar Ret urn


.01E L .01  ( Profits - interest)
 .01(VL  DL )

Dollar Investment Dollar Ret urn


Borrowing  .01D L - .01  Interest
Equity .01VU .01  Profits
Total .01(VU  D L ) .01  ( Profits - Interest)
17- 7

M&M (Debt Policy Doesn’t Matter)


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 B C D
Operating Income $500 1,000 1,500 2,000 Expected
Earnings per share $.50 1.00 1.50 2.00 outcome
Return on shares (%) 5% 10 15 20
17- 8

M&M (Debt Policy Doesn’t Matter)


Example Data
Number of shares 500
cont.
Price per share $10
50% debt Market Value of Shares $ 5,000
Market val ue of debt $ 5,000

Outcomes
A B C D
Operating Income $500 1,000 1,500 2,000
Interest $500 500 500 500
Equity earnings $0 500 1,000 1,500
Earnings per share $0 1 2 3
Return on shares (%) 0% 10 20 30
17- 9

M&M (Debt Policy Doesn’t Matter)


Example - Macbeth’s - All Equity Financed
- Debt replicated by investors

Outcomes
A B C D
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
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

Proposition I and Macbeth

Macbeth continued

Cuttent Structure : Proposed Structure :


All Equity Equal Debt and Equity
Expected earnings per share ($) 1.50 2.00
Price per share ($) 10 10
Expected return per share (%) 15 20
17- 12

Leverage and Returns

expected operating income


Expected return on assets  ra 
market val ue of all securities

 D   E 
rA   rD     rE  
 DE  DE
17- 13

M&M Proposition II
Macbeth continued
D
rE  rA   rA  rD 
V

expected operating income


rE  rA 
market val ue of all securities
1500
  .15
10,000
17- 14

M&M Proposition II
D
rE  rA   rA  rD  Macbeth continued
V
expected operating income
rE  rA 
market val ue of all securities
1500
  .15
10,000

5000
rE  .15   .15  .10
5000
 .20 or 20%
17- 15

Leverage and Risk


Macbeth continued
Leverage increases the risk of Macbeth shares
Operating Income
Change
$1,500 to $500
All equity Earnings per share ($) 1.50 0.50 - $1.00
Return on shares 15% 5% - 10%
50 % debt : Earnings per share ($) 2 0 - $2.00
Return on shares 20% 0 - 20%
17- 16

Leverage and Returns


Market Value Balance Sheet example

Asset Value 100 Debt (D) 40


Equity (E) 60
Asset Value 100 Firm Value (V) 100

rd = 7.5%  D   E 
rA   rD  
  E r  
re = 15%  DE  DE
 40   60 
rA   .075     .15    12.75%
 100   100 
17- 17

Leverage and Returns


Market Value Balance Sheet example – continued
What happens to Re when debt costs rise?
Asset Value 100 Debt (D) 40
Equity (E) 60
Asset Value 100 Firm Value (V) 100

rd = 7.5% changes to 7.875%


re = ??  40   60 
.1275   .07875     re  
 100   100 
re  16.0%
17- 18

Leverage and Returns

 D  E
BA   BD     BE  
 V  V

D
BE  B A   B A  BD 
V
17- 19

WACC

 WACC is the traditional view of capital


structure, risk and return.

 D  E
WACC  rA   rD     rE  
 V  V
17- 20

WACC
r

rE

rE =WACC

rD
D
V
17- 21

M&M Proposition II
r
rE

rA

rD
D
Risk free debt Risky debt E
17- 22

WACC (traditional view)


r
rE

WACC

rD
D
V
17- 23

WACC (M&M view)


r
rE

WACC

rD
D
V
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.

 D  E
WACC   rD     rE  
 V  V
Old Formula
17- 25

After Tax WACC

Tax Adjusted Formula

D  E
WACC  rD  (1  Tc )      rE  
V   V
17- 26

After Tax WACC


Example - Union Pacific

The firm 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- 27

After Tax WACC


Example - Union Pacific - continued

Balance Sheet (Market Value, billions)


Assets 22.6 7.6 Debt
15 Equity
Total assets 22.6 22.6 Total liabilities

MARKET VALUES
17- 28

After Tax WACC


Example - Union Pacific - continued

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

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

D  E
WACC  rD  (1  Tc )      rE  
V   V
17- 29

After Tax WACC


Example - Union Pacific - continued

D  E
WACC  rD  (1  Tc )      rE  
V   V

WACC  .055  (1  .35) .34   .10 .66


 .078
 7.8%
17- 30

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