Does Debt Policy Matter ?
Principles of Corporate Finance
Seventh Edition
Richard A. Brealey
Stewart C. Myers
Slides by
Matthew Will
Chapter 17
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17- 2
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Topics Covered
Leverage in a Tax Free Environment How Leverage Affects Returns The Traditional Position
17- 3
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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.
17- 4
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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
17- 5
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Example - Macbeth Spot Removers - All Equity Financed
201510% 5(%) shares on Return
2.001.501.00$.50shareper Earnings
2,0001,5001,000$500Income Operating
D C BA
Outcomes
10,000 $Shares of ValueMarket
$10shareper Price
1,000shares ofNumber
Data
M&M (Debt Policy Doesn’t Matter)
Expected outcome
17- 6
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Example
cont.
50% debt
M&M (Debt Policy Doesn’t Matter)
3020100%(%) shares on Return
321$0shareper Earnings
500,11,000500$0earningsEquity
500500500$500Interest
000,21,5001,000$500Income Operating
CBA
Outcomes
5,000 $debt of ueMarket val
5,000 $Shares of ValueMarket
$10shareper Price
500shares ofNumber
Data
D
17- 7
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Example - Macbeth’s - All Equity Financed
- Debt replicated by investors
3020100%(%) investment$10 on Return
3.002.001.000 $investment on earningsNet
1.001.001.00$1.0010% @Interest :LESS
4.003.002.00$1.00shares twoon Earnings
DCBA
Outcomes
M&M (Debt Policy Doesn’t Matter)
17- 8
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MM'S PROPOSITION I
If capital markets are doing their job, firms cannot increase value by tinkering with capital structure.
V is independent of the debt ratio.
AN EVERYDAY ANALOGY
It should cost no more to assemble a chicken than to buy one whole.
No Magic in Financial Leverage
17- 9
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Proposition I and Macbeth
2015(%) shareper return Expected
1010($) shareper Price
2.001.50($) shareper earnings Expected Equityand Debt Equal
:Structure Proposed
EquityAll
:StructureCuttent
Macbeth continued
17- 10
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Leverage and Returns
securities all of uemarket val
income operating expectedr assets on return Expected a
EDA r
ED
Er
AD
Dr
17- 11
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M&M Proposition II
15.000,10
1500securities all of uemarket val
income operating expectedr r AE
DAAE rrV
Drr
Macbeth continued
17- 12
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M&M Proposition II
15.000,10
1500securities all of uemarket val
income operating expectedr r AE
DAAE rrV
Drr
20%or 20.
10.15.5000
500015.
Er
Macbeth continued
17- 13
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r
DE
rD
rE
M&M Proposition II
rA
Risk free debt Risky debt
17- 14
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Leverage and Risk
200shares on Return
20($) shareper Earnings:debt % 50
155shares on Return
1.50.50($) shareper Earningsequity All$1,500
Income
$500
Operating
200shares on Return
20($) shareper Earnings:debt % 50
155shares on Return
1.50.50($) shareper Earningsequity All$1,500
Income
$500
Operating
Macbeth continued
Leverage increases the risk of Macbeth shares
17- 15
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Leverage and Returns
EDA B
ED
EB
AD
DB
EDA B
ED
EB
AD
DB
DAAE BBV
DBB DAAE BB
V
DBB
17- 16
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WACC
EDA r
V
Er
V
DrWACC
EDA r
V
Er
V
DrWACC
WACC is the traditional view of capital structure, risk and return.
17- 17
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WACC
.10=rD
.20=rE
.15=rA
BEBABDRisk
Expected Return
Equity
All assets
Debt
17- 18
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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 = 2 + 3 = $5 million
17- 19
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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 = 2 + 3 = $5 million
12.2%or 122.
15.5
308.
5
2
ED r
V
Er
V
DWACC
12.2%or 122.
15.5
308.
5
2
ED r
V
Er
V
DWACC
17- 20
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r
DV
rD
rE
rE =WACC
WACC
17- 21
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r
DV
rD
rE
WACC
WACC (traditional view)
17- 22
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r
DV
rD
rE
WACC
WACC (M&M view)