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Chapter 17 Principles of Corporate Finance Eighth Edition Does Debt Policy Matter? Slides by Matthew Will Copyright © 2006 by The McGraw-Hill Companies,

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Presentation on theme: "Chapter 17 Principles of Corporate Finance Eighth Edition Does Debt Policy Matter? Slides by Matthew Will Copyright © 2006 by The McGraw-Hill Companies,"— Presentation transcript:

1 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

2 Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 17- 2 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

3 Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 17- 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 17- 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 17- 5 McGraw-Hill/Irwin M&M (Debt Policy Doesn’t Matter)

6 Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 17- 6 McGraw-Hill/Irwin M&M (Debt Policy Doesn’t Matter)

7 Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 17- 7 McGraw-Hill/Irwin Example - Macbeth Spot Removers - All Equity Financed M&M (Debt Policy Doesn’t Matter) Expected outcome

8 Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 17- 8 McGraw-Hill/Irwin Example cont. 50% debt M&M (Debt Policy Doesn’t Matter)

9 Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 17- 9 McGraw-Hill/Irwin Example - Macbeth’s - All Equity Financed - Debt replicated by investors M&M (Debt Policy Doesn’t Matter)

10 Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 17- 10 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

11 Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 17- 11 McGraw-Hill/Irwin Proposition I and Macbeth Macbeth continued

12 Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 17- 12 McGraw-Hill/Irwin Leverage and Returns

13 Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 17- 13 McGraw-Hill/Irwin M&M Proposition II Macbeth continued

14 Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 17- 14 McGraw-Hill/Irwin M&M Proposition II Macbeth continued

15 Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 17- 15 McGraw-Hill/Irwin Leverage and Risk Macbeth continued Leverage increases the risk of Macbeth shares

16 Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 17- 16 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

17 Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 17- 17 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?

18 Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 17- 18 McGraw-Hill/Irwin Leverage and Returns

19 Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 17- 19 McGraw-Hill/Irwin WACC  WACC is the traditional view of capital structure, risk and return.

20 Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 17- 20 McGraw-Hill/Irwin r DVDV rDrD rErE r E =WACC WACC

21 Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 17- 21 McGraw-Hill/Irwin r DEDE rDrD rErE M&M Proposition II rArA Risk free debtRisky debt

22 Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 17- 22 McGraw-Hill/Irwin r DVDV rDrD rErE WACC WACC (traditional view)

23 Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 17- 23 McGraw-Hill/Irwin r DVDV rDrD rErE WACC WACC (M&M view)

24 Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 17- 24 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

25 Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 17- 25 McGraw-Hill/Irwin After Tax WACC Tax Adjusted Formula

26 Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 17- 26 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?

27 Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 17- 27 McGraw-Hill/Irwin After Tax WACC Example - Union Pacific - continued MARKET VALUES

28 Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 17- 28 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%

29 Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 17- 29 McGraw-Hill/Irwin After Tax WACC Example - Union Pacific - continued

30 Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 17- 30 McGraw-Hill/Irwin Web Resources www.finance.yahoo.com/ www.valuepro.net Click to access web sites Internet connection required

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