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

2. 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

3. 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. 3

4. 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 4

5. M&M (Debt Policy Doesn’t Matter)

6. M&M (Debt Policy Doesn’t Matter)

7. M&M (Debt Policy Doesn’t Matter)
Example - Macbeth Spot Removers - All Equity Financed
Expected outcome 5

8. M&M (Debt Policy Doesn’t Matter)
Example
cont.
50% debt 6

9. M&M (Debt Policy Doesn’t Matter)
Example - Macbeth’s All Equity Financed
- Debt replicated by investors 7

10. No Magic in Financial Leverage
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.

11. Proposition I and Macbeth
Macbeth continued

12. Leverage and Returns

13. M&M Proposition II
Macbeth continued

14. M&M Proposition II
Macbeth continued

15. Leverage and Risk Macbeth continued
Leverage increases the risk of Macbeth shares

16. Market Value Balance Sheet example
Leverage and Returns
Market Value Balance Sheet example
Asset Value 100 Debt (D) 40
Equity (E) 60
Asset Value 100 Firm Value (V) 100
rd = 7.5%
re = 15%

17. Market Value Balance Sheet example – continued
Leverage and Returns
Market Value Balance Sheet example – continued
What happens to Re when debt costs rise?
Asset Value 100 Debt (D) 40
Equity (E) 60
Asset Value 100 Firm Value (V) 100
rd = 7.5% changes to 7.875%
re = ??

18. Leverage and Returns

19. WACC
WACC is the traditional view of capital structure, risk and return.

20. WACC r rE
rE =WACC rD D V 8

21. M&M Proposition II r rE rA rD D E
Risk free debt
Risky debt 9

22. WACC (traditional view)rE
WACC rD D V 8

23. WACC (M&M view) r rE
WACC rD D V 9

24. 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

25. After Tax WACC
Tax Adjusted Formula

26. 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?

27. After Tax WACC
Example - Union Pacific - continued
MARKET VALUES

28. 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%

29. After Tax WACC
Example - Union Pacific - continued

30. Web Resources Web Links www.finance.yahoo.com/ www.valuepro.net
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