1. The McGraw-Hill Companies, Inc., 2000
Principles of Corporate Finance
Brealey and Myers Sixth Edition
Does Debt Policy Matter?
Slides by
Matthew Will
Chapter 17
Irwin/McGraw Hill
The McGraw-Hill Companies, Inc., 2000

2. Topics Covered Leverage in a Tax Free Environment
How Leverage Effects Returns
The Traditional Position

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)
Example - Macbeth Spot Removers - All Equity Financed
Expected outcome 5

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

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

8. 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.

9. Proposition I and Macbeth
Macbeth continued

10. Leverage and Returns

11. M&M Proposition II
Macbeth continued

12. M&M Proposition II
Macbeth continued

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

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

15. Leverage and Returns

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

17. WACC Expected Return .20=rE .15=rA .10=rD Risk BD BA BE Equity
All assets
.10=rD
Debt
Risk BD BA BE

18. 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

19. 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

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

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

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