Does Debt Policy Matter?
Does Debt Policy Matter?
Does Debt Policy Matter?
Capital Structure
17- 3
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
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
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
AN EVERYDAY ANALOGY
Macbeth continued
D E
rA rD rE
DE DE
17- 13
M&M Proposition II
Macbeth continued
D
rE rA rA rD
V
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
rd = 7.5% D E
rA rD
E r
re = 15% DE DE
40 60
rA .075 .15 12.75%
100 100
17- 17
D E
BA BD BE
V V
D
BE B A B A BD
V
17- 19
WACC
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
rD
D
V
17- 23
WACC
rD
D
V
17- 24
D E
WACC rD rE
V V
Old Formula
17- 25
D E
WACC rD (1 Tc ) rE
V V
17- 26
MARKET VALUES
17- 28
D E
WACC rD (1 Tc ) rE
V V
17- 29
D E
WACC rD (1 Tc ) rE
V V
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