Does Debt Policy Matter?

Principles of Corporate FinanceBrealey and Myers Sixth Edition

Slides by

Matthew Will Chapter 17

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Topics Covered

Leverage in a Tax Free Environment How Leverage Effects Returns The Traditional Position

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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.

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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

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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

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Example

cont.

50% debt

M&M (Debt Policy Doesn’t Matter)

3025150%(%) 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

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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)

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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

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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

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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

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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

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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

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r

DE

rD

rE

M&M Proposition II

rA

Risk free debt Risky debt

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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

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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

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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.

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WACC

.10=rD

.20=rE

.15=rA

BEBABDRisk

Expected Return

Equity

All assets

Debt

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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

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WACCExample - 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

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r

DV

rD

rE

rE =WACC

WACC

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r

DV

rD

rE

WACC

WACC (traditional view)

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r

DV

rD

rE

WACC

WACC (M&M view)