Chapter 17 and parts 18

Principles of Corporate Finance

Tenth Edition

Does Debt Policy Matter?

Slides by

Matthew Will and Bo Sjö(2012)

McGraw-Hill/Irwin Copyright © 2011 by the McGraw-Hill Companies, Inc. All rights reserved.

17-2

Topics Covered

�Financial Leverage in a Competitive Tax Free Environment

�Financial Risk and Expected Returns

�The Weighted Average Cost of Capital

�Theories of optimal debt-equity ratio

�A Final Word on After Tax WACC

17-3

M&M (Debt Policy Doesn’t Matter)

�Modigliani & Miller

– When there are no taxes and capital markets function well, no bankruptcy costs, management and owners have the same information, 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.

– D/E cannot change the value of the firm since it D/E does not affect the FCF of the firm

17-4

M&M formulated two Propositions

�We do prove these propositions here

�Proposition I: Under the assumptions above, the capital structure does not affect the value of the firm.

�This is so because the D/E does not affect the cash flows. The earnings are the same irrespectible of how they are financed

17-5

Proposition II

�The cost of equity will increase in the same proportion as the D/E ratio.

�Cost of debt is lower than cost of equity –yes. But way?

�Look at WACC (without taxes)

�It seems as if is cheaper to borrow compared to issue stocks?

�This conclusion is wrong.

�Think of an all-equity firm.

17-6

Proposition II

�As the all equity firm starts to borrow the firm’s cost of equity will increase so that WACC is constant.

�With debt financing, the expected free cash flow to euity holders become more volatile (=risky)

�In good times share-holders keep more. But in bad times, interest must be paid and share-holders get less.

�Thus, WACC is constant as D/E is changing.

17-7

Borrowing and EPS at Macbeth17-8

MM'S PROPOSITION I

If capital markets are doing their job,firms cannot increase value by tinkeringwith 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

Leverage and Returns

securities all of uemarket val

income operating expectedr assets on return Expected a ==

×+

+

×+

= EDA rED

Er

ED

Dr

17-10

M&M Proposition II

( )E

Drrrr DAAE −+=

17-11

WACC

+×+

+×==

ED

Er

ED

DrrWACC EDA

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

17-12

M&M Proposition II

17-13

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.

×+

×=V

Er

V

DrWACC ED

Old Formula

17-14

After Tax WACC

×+

×−×=V

Er

V

DTcrWACC ED )1(

Tax Adjusted Formula

17-15

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?

17-16

After Tax WACC

Example - Union Pacific - continued

Balance Sheet (Market Value, billions)Assets 200 63 Debt

137 EquityTotal assets 200 200 Total liabilities

MARKET VALUES

17-17

After Tax WACC

Example - Union Pacific - continued

×+

×−×=V

Er

V

DTcrWACC ED )1(

Debt ratio = (D/V) = 63/200= .315 or 31.5%

Equity ratio = (E/V) = 137/200 = .685 or 68.5%

17-18

After Tax WACC

Example - Union Pacific - continued

×+

×−×=V

Er

V

DTcrWACC ED )1(

( ) ( )

%4.8

084.

685.099.315.078.)35.1(

==

+××−=WACC

17-19

The Trade-Off Theory

�With taxes it seems as if the firm should borrow more and more.

�The balancing item is the costs associated with bankruptcy.

�This leads to the Trade-Off theory, increase debt as long as it reduces WACC. After the optimal (D/E) point WACC starts to increase. Figure 18.2

�A good argument for banks. And firms should not have AAA (AA) or A ratings, they should borrow.

17-20

Trade-Off Theory

�The theory have some empirical support. Old established firms borrows more than younger more risky firms, p 486-487..

�But, besides from that we do not know.

�

17-21

The Pecking-Order Theory

�Cost of financing:�From cheaper to more expensive:�Retained earnings�Bank loans�Issue bonds�Issue stocks�This theory is part of the picture, but not that

important in real life. Fast growing firms often relay on refinancing cash flows, since t is expesive to issue stocks. . Page 488-491.

17-22

Agency Problem Theory

�The final theory is Agency –Theory

�Managers are afraid of bankruptcy because it ruins their jobmarket. They cannot find a new job if the firm goes bust.

�Thus, borrow to ’force’ management to generate at least suffienct free cash flows to pay interest with some margin. Otherwise they will be too lazy.

17-23

Empirical research?

A lot of research:

�What do we know about Debt/Equity?

�Empirical research is for and against all theories.

�Conclusion is ???? We don’t know.

17-24

Web Resources

Click to access web sites

Internet connection required

http://finance.yahoo.com

www.valuepro.net