DOES DEBT POLICY MATTER? 17 DOES DEBT POLICY MATTER?

17-1 EFFECT of FINANCIAL LEVERAGE on Competitive TAX-FREE ECONOMY Modigliani & Miller When firm pays no taxes and capital markets function well, no difference if firm borrows or individual shareholders borrow Hence market value of company does not depend on capital structure This is Modigliani and Miller Proposition I.

17-1 EFFECT of FINANCIAL LEVERAGE on Competitive TAX-FREE ECONOMY M&M Debt Policy Does Not Matter This assumes that you own 1% of an unlevered (all equity) firm and also an equivalent levered firm. The return associated with that level of ownership is also given.

17-1 EFFECT of FINANCIAL LEVERAGE on Competitive TAX-FREE ECONOMY M&M Debt Policy Does Not Matter This shows the ownership of 1% of an equivalent levered firm. The return associated with that level of ownership and borrowing on the personal account is given. In other words the investor is able to replicate the borrowing by the firm.

TABLE 17.1 MACBETH SPOT REMOVERS Here is a numerical example to illustrate MM proposition I. For an all-equity firm, return on equity is equal to return on assets. There are no taxes. The returns to the stockholders are shown under different assumptions about operating income.

TABLE 17.2 MACBETH SPOT REMOVERS The numerical example shows the outcomes for an equivalent levered firm with 50% debt. Expected return on equity is higher. This shows the return to shareholders under different assumptions about operating income.

FIGURE 17.1 BORROWING INCREASES MACBETH’s EPS The price per share remains the same, but the expected return per share increases with leverage. This is also called EBIT-EPS analysis. At income levels less than $1,000, an all-equity firm is better. At income levels greater than $1,000 a levered firm is better.

17-1 EFFECT of FINANCIAL LEVERAGE on Competitive TAX-FREE ECONOMY Proposition 1 Capital markets do their job Keeps firms from increasing value by changing capital structure Value is independent from debt ratio Example Costs no more to assemble chicken than buy one MM Proposition I: Value of a firm is independent of the debt ratio An everyday analogy: It should cost no more to assemble a chicken than to buy one whole.

TABLE 17.3 INVESTORs REPLICATE MACBETH'S LEVERAGE Shareholders under all-equity-financed firm can replicate the firm’s leverage by borrowing on their account. Here the investor is borrowing $10 at 10% and buying the second share. The investor, by borrowing on his own account, can replicate the outcome of the levered firm. The firms should have the same value.

17-2 FINANCIAL RISK and EXPECTED RETURNS Proposition I and Macbeth Macbeth example is continued here For the all equity situation : EPS = $1.50; Price = 10 ; therefore Expected return = 15% For equal debt and equity situation: EPS = $2.00; Price = 10 ; therefore Expected return = 20%%

17-2 FINANCIAL RISK and EXPECTED RETURNS Leverage and Returns Expected return on assets = rA = (expected operating income)/(market value of all securities) rA = [D/(D+E)](rD) + [E/( D+E)](rE); rA(D+E) = (D)(rD) + E(rE); rE = rA(D/E + 1) – rD(D/E); rE = rA + [D/E](rA – rD); For an all-equity firm rA = rE = 0.15

17-2 FINANCIAL RISK and EXPECTED RETURNS Proposition II and MM rE = rA + [D/E](rA – rD); For an all-equity firm rA = rE = 0.15

17-2 FINANCIAL RISK and EXPECTED RETURNS Proposition II and MM If D/E = 1, rE = 0.15 + 1(0.15 – 0.1) = 0.20 = 20%; Return on equity increases linearly with leverage (debt-equity ratio): rE = rA + [D/E](rA – rD); This is MM’s Proposition II.

TABLE 17.4 LEVERAGE and RISK MACBETH SHARES If the income level falls to $500 then: For the all equity situation: EPS = $0.50; Price = 10 ; Expected return = 5% ; Change = –10% For equal debt and equity situation: EPS = $0.00; Price = 10 ; Expected return = 0%; Change = –20% Here the relationship between leverage and returns are shown. This is in accordance with MM’s Proposition II.

EXAMPLE 17.1 LEVERAGE and COST OF EQUITY Leverage and Returns rA = [D/(D+E)](rD) + [E/( D+E)](rE); if rD = 7.5% and rE = 15% Then rA = (0.4)(7.5) + (0.6)(15) = 12.75%; Where D/V = 40% and E/V = 60% ;(V = D+E) Return on equity of a levered firm is higher if the cost of debt increases with leverage.

17-2 FINANCIAL RISK and EXPECTED RETURNS Leverage and Returns rD = 7.875% rE = ??%; 0.1275 = (0.0785)(0.4) + (0.6)( rE) rE = 16%

17-2 FINANCIAL RISK and EXPECTED RETURNS Leverage and Returns A similar relationship can be obtained for betas. βA = βD(D/V) + βE (E/V) βE = βA + [D/E]( βA – βD); [Note: If the debt is risk free then βD = 0]

17-3 WEIGHTED-AVERAGE COST OF CAPITAL Weighted-Average Cost of Capital (WACC) The weighted average cost of capital is the weighted average of debt and equity returns. WACC = rA = [D/(D+E)]×(rD) + [E/( D+E)] × (rE) = [D/V] × (rD) + [E/V] × (rE)

FIGURE 17.2 PROPOSITION II and MM This graph shows that the WACC remains constant as leverage increases, according to MM Proposition I.

FIGURE 17.3 WACC TRADITIONAL VIEW The traditionalists say that borrowing at first increases rE more slowly than MM predicts, but rE shoots up with higher levels of debt. Using the right amount of debt can minimize the Weighted Average Cost of Capital. This graph also shows that the WACC remains constant as leverage increases and is consistent with MM Proposition I.

17-4 FINAL WORD ON AFTER-TAX WEIGHTED-AVERAGE COST of CAPITAL After-Tax WACC Tax benefit from interest-expense deductibility must include cost of funds Tax benefit reduces effective cost of debt by factor of marginal tax rate This shows the formula for the weighted average cost of capital (WACC).

17-4 FINAL WORD ON AFTER-TAX WEIGHTED-AVERAGE COST of CAPITAL Union Pacific Firm has marginal tax rate of 35% Cost of equity 9.9% Pretax cost of debt 4.7% Given book-and-market value balance sheet what is tax-adjusted WACC? Here is a numerical example to illustrate how to estimate the cost of capital for Union Pacific Company.

17-4 FINAL WORD ON AFTER-TAX WEIGHTED-AVERAGE COST of CAPITAL Union Pacific WACC = (1 – .35) x 4.7 x .160 + 9.9 x .840 = 8.8% Answer to the example from slide 24

FIGURE 17.4 UNION PACIFIC WACC This graph shows the theoretical cost of capital at various debt to equity ratios.