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Transcript of Does Debt Policy Matter? Principles of Corporate Finance Brealey and Myers Sixth Edition Slides by...
Does Debt Policy Matter?
Principles of Corporate FinanceBrealey and Myers Sixth Edition
Slides by
Matthew Will Chapter 17
©The McGraw-Hill Companies, Inc., 2000Irwin/McGraw Hill
©The McGraw-Hill Companies, Inc., 2000Irwin/McGraw Hill
17- 2
Topics Covered
Leverage in a Tax Free Environment How Leverage Effects Returns The Traditional Position
©The McGraw-Hill Companies, Inc., 2000Irwin/McGraw Hill
17- 3
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.
©The McGraw-Hill Companies, Inc., 2000Irwin/McGraw Hill
17- 4
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
©The McGraw-Hill Companies, Inc., 2000Irwin/McGraw Hill
17- 5
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
©The McGraw-Hill Companies, Inc., 2000Irwin/McGraw Hill
17- 6
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
©The McGraw-Hill Companies, Inc., 2000Irwin/McGraw Hill
17- 7
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$1.00shares twoon Earnings
DCBA
Outcomes
M&M (Debt Policy Doesn’t Matter)
©The McGraw-Hill Companies, Inc., 2000Irwin/McGraw Hill
17- 8
MM'S PROPOSITION I
If capital markets are doing their job, firms cannot increase value by tinkering with capital structure.
V is independent of the debt ratio.
AN EVERYDAY ANALOGY
It should cost no more to assemble a chicken than to buy one whole.
No Magic in Financial Leverage
©The McGraw-Hill Companies, Inc., 2000Irwin/McGraw Hill
17- 9
Proposition I and Macbeth
2015(%) shareper return Expected
1010($) shareper Price
2.001.50($) shareper earnings Expected Equityand Debt Equal
:Structure Proposed
EquityAll
:StructureCuttent
Macbeth continued
©The McGraw-Hill Companies, Inc., 2000Irwin/McGraw Hill
17- 10
Leverage and Returns
securities all of uemarket val
income operating expectedr assets on return Expected a
EDA r
ED
Er
AD
Dr
©The McGraw-Hill Companies, Inc., 2000Irwin/McGraw Hill
17- 11
M&M Proposition II
15.000,10
1500securities all of uemarket val
income operating expectedr r AE
DAAE rrV
Drr
Macbeth continued
©The McGraw-Hill Companies, Inc., 2000Irwin/McGraw Hill
17- 12
M&M Proposition II
15.000,10
1500securities all of uemarket val
income operating expectedr r AE
DAAE rrV
Drr
20%or 20.
10.15.5000
500015.
Er
Macbeth continued
©The McGraw-Hill Companies, Inc., 2000Irwin/McGraw Hill
17- 13
r
DE
rD
rE
M&M Proposition II
rA
Risk free debt Risky debt
©The McGraw-Hill Companies, Inc., 2000Irwin/McGraw Hill
17- 14
Leverage and Risk
200shares on Return
20($) 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
©The McGraw-Hill Companies, Inc., 2000Irwin/McGraw Hill
17- 15
Leverage and Returns
EDA B
ED
EB
AD
DB
EDA B
ED
EB
AD
DB
DAAE BBV
DBB DAAE BB
V
DBB
©The McGraw-Hill Companies, Inc., 2000Irwin/McGraw Hill
17- 16
WACC
EDA r
V
Er
V
DrWACC
EDA r
V
Er
V
DrWACC
WACC is the traditional view of capital structure, risk and return.
©The McGraw-Hill Companies, Inc., 2000Irwin/McGraw Hill
17- 17
WACC
.10=rD
.20=rE
.15=rA
BEBABDRisk
Expected Return
Equity
All assets
Debt
©The McGraw-Hill Companies, Inc., 2000Irwin/McGraw Hill
17- 18
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
©The McGraw-Hill Companies, Inc., 2000Irwin/McGraw Hill
17- 19
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
©The McGraw-Hill Companies, Inc., 2000Irwin/McGraw Hill
17- 21
r
DV
rD
rE
WACC
WACC (traditional view)