Does Debt Policy Matter ? Principles of Corporate Finance Seventh Edition Richard A. Brealey Stewart C. Myers Slides by Matthew Will Chapter 17 McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved

17- 2 McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved Topics Covered  Leverage in a Tax Free Environment  How Leverage Affects Returns  The Traditional Position

17- 3 McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved 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 McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved 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 McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved Example - Macbeth Spot Removers - All Equity Financed M&M (Debt Policy Doesn’t Matter) Expected outcome

17- 6 McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved Example cont. 50% debt M&M (Debt Policy Doesn’t Matter)

17- 7 McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved Example - Macbeth’s - All Equity Financed - Debt replicated by investors M&M (Debt Policy Doesn’t Matter)

17- 8 McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved 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- 9 McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved Proposition I and Macbeth Macbeth continued

McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved Leverage and Returns

McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved M&M Proposition II Macbeth continued

McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved M&M Proposition II Macbeth continued

McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved r DEDE rDrD rErE M&M Proposition II rArA Risk free debtRisky debt

McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved Leverage and Risk Macbeth continued Leverage increases the risk of Macbeth shares

McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved Leverage and Returns

McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved WACC  WACC is the traditional view of capital structure, risk and return.

McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved WACC.10=r D.20=r E.15=r A BEBE BABA BDBD Risk Expected Return Equity All assets Debt

McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved WACC Example - A firm has $2 mil of debt and 100,000 of outstanding shares at $30 each. If they can borrow at 8% and the stockholders require 15% return what is the firm’s WACC? D = $2 million E = 100,000 shares X $30 per share = $3 million V = D + E = = $5 million

McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved WACC Example - A firm has $2 mil of debt and 100,000 of outstanding shares at $30 each. If they can borrow at 8% and the stockholders require 15% return what is the firm’s WACC? D = $2 million E = 100,000 shares X $30 per share = $3 million V = D + E = = $5 million

McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved r DVDV rDrD rErE r E =WACC WACC

McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved r DVDV rDrD rErE WACC WACC (traditional view)

McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved r DVDV rDrD rErE WACC WACC (M&M view)