Chapter 17 Principles of Corporate Finance Tenth Edition

Chapter 17 Principles of Corporate Finance Tenth Edition Does Debt Policy Matter? Slides by Matthew Will Mc. Graw-Hill/Irwin Copyright © 2011 by the Mc. Graw-Hill Companies, Inc. All rights reserved.

Topics Covered Ø Financial Leverage in a Competitive Tax Free Environment Ø Financial Risk and Expected Returns Ø The Weighted Average Cost of Capital Ø A Final Word on After Tax WACC 17 -2

M&M (Debt Policy Doesn’t Matter) Ø 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. 17 -3

M&M (Debt Policy Doesn’t Matter) Assumptions Ø 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 Ø Capital structure does not affect cash flows e. g. . . – No taxes – No bankruptcy costs – No effect on management incentives 17 -4

M&M (Debt Policy Doesn’t Matter) 17 -5

M&M (Debt Policy Doesn’t Matter) 17 -6

M&M (Debt Policy Doesn’t Matter) 17 -7 Example - Macbeth Spot Removers - All Equity Financed Expected outcome

M&M (Debt Policy Doesn’t Matter) Example cont. 50% debt 17 -8

M&M (Debt Policy Doesn’t Matter) Example - Macbeth’s - All Equity Financed - Debt replicated by investors 17 -9

Borrowing and EPS at Macbeth 17 -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. 17 -11

Proposition I and Macbeth continued 17 -12

Leverage and Returns 17 -13

M&M Proposition II Macbeth continued 17 -14

M&M Proposition II Macbeth continued 17 -15

Leverage and Risk Macbeth continued Leverage increases the risk of Macbeth shares 17 -16

Leverage and Returns Market Value Balance Sheet example Asset Value rd = 7. 5% re = 15% 100 Debt (D) 40 Equity (E) 60 Firm Value (V) 100 17 -17

Leverage and Returns Market Value Balance Sheet example – continued What happens to Re when debt costs rise? Asset Value 100 rd = 7. 5% changes to 7. 875% re = ? ? Debt (D) 40 Equity (E) 60 Firm Value (V) 100 17 -18

Leverage and Returns 17 -19

WACC Ü WACC is the traditional view of capital structure, risk and return. 17 -20

17 -21 WACC r r. E r. A = WACC r. D D V

M&M Proposition II 17 -22

WACC (traditional view) 17 -23

After Tax WACC Ø The tax benefit from interest expense deductibility must be included in the cost of funds. Ø This tax benefit reduces the effective cost of debt by a factor of the marginal tax rate. Old Formula 17 -24

After Tax WACC Tax Adjusted Formula 17 -25

After Tax WACC Example - Union Pacific The firm has a marginal tax rate of 35%. The cost of equity is 9. 9% and the pretax cost of debt is 7. 8%. Given the book and market value balance sheets, what is the tax adjusted WACC? 17 -26

After Tax WACC Example - Union Pacific - continued MARKET VALUES 17 -27

After Tax WACC Example - Union Pacific - continued Debt ratio = (D/V) = 63/200=. 315 or 31. 5% Equity ratio = (E/V) = 137/200 =. 685 or 68. 5% 17 -28

After Tax WACC Example - Union Pacific - continued 17 -29

Union Pacific WACC 17 -30

After Tax WACC 17 -31 Another Example - Kate’s Cafe Kate’s Café 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?

After Tax WACC Another Example - Kate’s Cafe- continued MARKET VALUES 17 -32

After Tax WACC Another Example - Kate’s Cafe- continued Debt ratio = (D/V) = 7. 6/22. 6=. 34 or 34% Equity ratio = (E/V) = 15/22. 6 =. 66 or 66% 17 -33

After Tax WACC Another Example - Kate’s Cafe- continued 17 -34

Web Resources Click to access web sites Internet connection required http: //finance. yahoo. com www. valuepro. net 17 -35