1. Chapter 17 Principles of Corporate Finance Eighth Edition Capital Budgeting and Risk Slides by Matthew Will, adopted by Craig Mayberry Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin Week 7 Seminar Chapters 17 and 18

2. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 9- 2 McGraw-Hill/Irwin 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

3. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 9- 3 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.

4. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 9- 4 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

5. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 9- 5 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

6. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 9- 6 McGraw-Hill/Irwin Leverage and Returns

7. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 9- 7 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

8. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 9- 8 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?

9. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 9- 9 McGraw-Hill/Irwin WACC  WACC is the traditional view of capital structure, risk and return.

10. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 9- 10 McGraw-Hill/Irwin r DVDV rDrD rErE r E =WACC WACC

11. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 9- 11 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

12. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 9- 12 McGraw-Hill/Irwin After Tax WACC Tax Adjusted Formula

13. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 9- 13 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?

14. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 9- 14 McGraw-Hill/Irwin After Tax WACC Example - Union Pacific - continued MARKET VALUES

15. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 9- 15 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%

16. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 9- 16 McGraw-Hill/Irwin After Tax WACC Example - Union Pacific - continued

17. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 9- 17 McGraw-Hill/Irwin Chapter 18 Principles of Corporate Finance Eighth Edition How Much Should a Firm Borrow? Slides by Matthew Will Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin

18. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 9- 18 McGraw-Hill/Irwin Financial Risk - Risk to shareholders resulting from the use of debt. Financial Leverage - Increase in the variability of shareholder returns that comes from the use of debt. Interest Tax Shield- Tax savings resulting from deductibility of interest payments. Capital Structure & Corporate Taxes

19. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 9- 19 McGraw-Hill/Irwin Capital Structure & Corporate Taxes The tax deductibility of interest increases the total distributed income to both bondholders and shareholders.

20. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 9- 20 McGraw-Hill/Irwin Example - You own all the equity of Space Babies Diaper Co. The company has no debt. The company’s annual cash flow is $900,000 before interest and taxes. The corporate tax rate is 35% You have the option to exchange 1/2 of your equity position for 5% bonds with a face value of $2,000,000. Should you do this and why? Capital Structure & Corporate Taxes

21. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 9- 21 McGraw-Hill/Irwin Capital Structure & Corporate Taxes Example - You own all the equity of Space Babies Diaper Co. The company has no debt. The company’s annual cash flow is $900,000 before interest and taxes. The corporate tax rate is 35% You have the option to exchange 1/2 of your equity position for 5% bonds with a face value of $2,000,000. Should you do this and why? Total Cash Flow All Equity = 585 *1/2 Debt = 620 (520 + 100)

22. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 9- 22 McGraw-Hill/Irwin Capital Structure & Corporate Taxes PV of Tax Shield = (assume perpetuity) D x r D x Tc r D = D x Tc Example: Tax benefit = 2,000,000 x (.05) x (.35) = $35,000 PV of $35,000 in perpetuity = 35,000 /.05 = $700,000 PV Tax Shield = $2,000,000 x.35 = $700,000

23. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 9- 23 McGraw-Hill/Irwin C.S. & Taxes (Personal & Corp) Corporate Tax Income after Corp Taxes $1.00 TpTp $1.00 – T p Personal Taxes. Income after All Taxes $1.00–T c -T pE (1.00-T c ) =(1.00-T pE )(1.00-T c ) TpE (1.00-Tc) $1.00 – T c TcTc None To bondholdersTo stockholders Operating Income ($1.00) Paid out as interest Or paid out as equity income

24. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 9- 24 McGraw-Hill/Irwin Capital Structure Structure of Bond Yield Rates D E Bond Yield r

25. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 9- 25 McGraw-Hill/Irwin Chapter 17 Practice Problem

26. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 9- 26 McGraw-Hill/Irwin Chapter 17 Practice Problem- Solution  The market value of the firm’s equity increases by $30 million, the amount of the decrease in the market value of the firm’s existing debt. Therefore, the price of the stock increases to:  ($150 million + $30 million)/15 million shares = $12  b.Since the market price of the shares is $12, the company can buy back:  $60 million/$12 = 5 million shares  c.After the change in capital structure, the market value of the firm is unchanged:  Equity + Debt = (10 million  $12) + $130 million = $250 million  After the change in structure, the debt ratio is:  Debt/(Debt + Equity) = $130 million/$250 million = 0.52  The investors in the existing debt lose $30 million while the shareholders gain this $30 million. The value of each share increases by:  $30 million/15 million shares = $2