Chapter 17 Principles of Corporate Finance Eighth Edition Does Debt Policy Matter? Slides by Matthew Will Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin

Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin Topics Covered  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

Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin 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.

Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin 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

Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin M&M (Debt Policy Doesn’t Matter)

Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin M&M (Debt Policy Doesn’t Matter)

Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin Example - Macbeth Spot Removers - All Equity Financed M&M (Debt Policy Doesn’t Matter) Expected outcome

Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin Example cont. 50% debt M&M (Debt Policy Doesn’t Matter)

Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin Example - Macbeth’s - All Equity Financed - Debt replicated by investors M&M (Debt Policy Doesn’t Matter)

Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin 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

Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin Proposition I and Macbeth Macbeth continued

Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin Leverage and Returns

Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin M&M Proposition II Macbeth continued

Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin M&M Proposition II Macbeth continued

Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin Leverage and Risk Macbeth continued Leverage increases the risk of Macbeth shares

Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin Leverage and Returns Asset Value100Debt (D)40 Equity (E)60 Asset Value100Firm Value (V)100 r d = 7.5% r e = 15% Market Value Balance Sheet example

Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin Leverage and Returns Asset Value100Debt (D)40 Equity (E)60 Asset Value100Firm Value (V)100 r d = 7.5% changes to 7.875% r e = ?? Market Value Balance Sheet example – continued What happens to Re when debt costs rise?

Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin Leverage and Returns

Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin WACC  WACC is the traditional view of capital structure, risk and return.

Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin r DVDV rDrD rErE r E =WACC WACC

Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin r DEDE rDrD rErE M&M Proposition II rArA Risk free debtRisky debt

Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin r DVDV rDrD rErE WACC WACC (traditional view)

Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin r DVDV rDrD rErE WACC WACC (M&M view)

Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin 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. Old Formula

Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin After Tax WACC Tax Adjusted Formula

Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin 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?

Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin After Tax WACC Example - Union Pacific - continued MARKET VALUES

Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin 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%

Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin After Tax WACC Example - Union Pacific - continued

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