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Chp017
- 1. Principles of
Corporate Finance
Chapter 17 Eighth Edition
Does Debt Policy
Matter?
Slides by
Matthew Will
McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved
- 2. 17- 2
Topics Covered
Leverage in a Competitive Tax Free
Environment
Financial Risk and Expected Returns
The Weighted Average Cost of Capital
A Final Word on After Tax WACC
McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved
- 3. 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.
McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved
- 4. 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
McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved
- 5. 17- 5
M&M (Debt Policy Doesn’t Matter)
Rupee Investment Rupee Return
.01VU .01× Profits
Rupee Investment Rupee Return
Debt .01D L .01× Interest
Equity .01E L .01× (Profits-Interest)
Total .01(D L + E L ) .01× Profits
= .01VL
McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved
- 6. 17- 6
M&M (Debt Policy Doesn’t Matter)
Rupee Investment Rupee Return
.01E L .01× (Profits-interest)
= .01(VL − DL )
Rupee Investment Rupee Return
Borrowing −.01D L -.01× Interest
Equity .01VU .01× Profits
Total .01(VU + D L ) .01× (Profits-Interest)
McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved
- 7. 17- 7
M&M (Debt Policy Doesn’t Matter)
Example - Macbeth Spot Removers - All Equity Financed
Data
Number of shares 1,000
Price per share Rs.10
Market Value of Shares Rs. 10,000
Outcomes
A B C D
Operating Income Rs.500 1,000 1,500 2,000 Expected
Earnings per share Rs.0.50 1.00 1.50 2.00 outcome
Return on shares (%) 5% 10 15 20
McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved
- 8. 17- 8
M&M (Debt Policy Doesn’t Matter)
Example Data
Number of shares 500
cont.
Price per share Rs.10
50% debt Market Value of Shares Rs. 5,000
Market value of debt Rs. 5,000
Outcomes
A B C D
Operating Income Rs.500 1,000 1,500 2, 000
Interest Rs.500 500 500 500
Equity earnings Rs.0 500 1,000 1,500
Earnings per share Rs.0 1 2 3
Return on shares (%) 0% 10 20 nn
McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved
- 9. 17- 9
M&M (Debt Policy Doesn’t Matter)
Example - Macbeth’s - All Equity Financed
- Debt replicated by investors
Outcomes
A B C D
Earnings on two shares Rs.1.00 2.00 3.00 4.00
LESS: Interest @ 10% Rs.1.00 1.00 1.00 1.00
Net earnings on investment Rs.0 1.00 2.00 3.00
Return on $10 investment (%) 0% 10 20 30
McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved
- 10. 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.
McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved
- 11. 17- 11
Proposition I and Macbeth
Macbeth continued
Cuttent Structure: Proposed Structure:
All Equity Equal Debt and Equity
Expected earnings per share (Rs.) 1.50 2.00
Price per share (Rs.) 10 10
Expected return per share (%) 15 20
McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved
- 12. 17- 12
Leverage and Returns
expected operating income
Expected return on assets = ra =
market value of all securities
D E
rA = rD × + rE ×
D+E D+E
McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved
- 13. 17- 13
M&M Proposition II
Macbeth continued
D
rE = rA + ( rA − rD )
V
expected operating income
rE = rA =
market value of all securities
1500
= = .15
10,000
McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved
- 14. 17- 14
M&M Proposition II
D
rE = rA + ( rA − rD ) Macbeth continued
V
expected operating income
rE = rA =
market value of all securities
1500
= = .15
10,000
5000
rE = .15 + ( .15 − .10)
5000
= .20 or 20%
McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved
- 15. 17- 15
Leverage and Risk
Macbeth continued
Leverage increases the risk of Macbeth shares
Operating Income
Change
$1,500 to $500
All equity Earnings per share (Rs.) 1.50 0.50 -$1.00
Return on shares 15% 5% -10%
50 % debt: Earnings per share (Rs.) 2 0 -$2.00
Return on shares 20% 0 -20%
McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved
- 16. 17- 16
Leverage and Returns
Market Value Balance Sheet example
Asset Value 100 Debt (D) 40
Equity (E) 60
Asset Value 100 Firm Value (V) 100
rd = 7.5% D E
rA = rD × + rE ×
re = 15% D+E D+E
40 60
rA = .075 × + .15 × = 12.75%
100 100
McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved
- 17. 17- 17
Leverage and Returns
Market Value Balance Sheet example – continued
What happens to Re when debt costs rise?
Asset Value 100 Debt (D) 40
Equity (E) 60
Asset Value 100 Firm Value (V) 100
rd = 7.5% changes to 7.875%
re = ?? 40 60
.1275 = .07875 × + re ×
100 100
re = 16.0%
McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved
- 18. 17- 18
Leverage and Returns
D E
BA = BD × + BE ×
V V
D
BE = B A + ( B A − BD )
V
McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved
- 19. 17- 19
WACC
WACC is the traditional view of capital
structure, risk and return.
D E
WACC = rA = rD × + rE ×
V V
McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved
- 20. 17- 20
WACC
r
rE
rE =WACC
rD
D
V
McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved
- 21. 17- 21
M&M Proposition II
r
rE
rA
rD
D
Risk free debt Risky debt E
McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved
- 22. 17- 22
WACC (traditional view)
r
rE
WACC
rD
D
V
McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved
- 23. 17- 23
WACC (M&M view)
r
rE
WACC
rD
D
V
McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved
- 24. 17- 24
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.
D E
WACC = rD × + rE ×
V V
Old Formula
McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved
- 25. 17- 25
After Tax WACC
Tax Adjusted Formula
D E
WACC = rD × (1 − Tc) × + rE ×
V V
McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved
- 26. 17- 26
After Tax WACC
Example - Titan Industries Limited
The firm has a marginal tax rate of
33.66%. The cost of equity is 20.0%
and the pretax cost of debt is 8.48%.
Given the book and market value
balance sheets, what is the tax adjusted
WACC?
McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved
- 27. 17- 27
After Tax WACC
Example – Titan Industries - continued
Debt (D ) Rs 318 crores at rD 8.48%
Equity (E ) 2443.8 at rE 20%
Preference Capital (P) 40 at rP 12%
Firm value (V ) Rs 2802 million
MARKET VALUES
McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved
- 28. 17- 28
After Tax WACC
Example – Titan Industries - continued
Debt ratio = (D/V) = 318 / 2802 = .11 or 11%
Equity ratio = (E/V) = 2444 / 2802 = .87 or 87%
Preference Capital ratio = (P/V) = 0.02 or 2%
D E P
After-tax WACC = rD (1 − Tc ) + rE + rP
V V V
McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved
- 29. 17- 29
After Tax WACC
Example – Titan Industries -
continued
D E P
WACC = rD (1 − Tc ) + rE + rP
V V V
After-tax WACC = 0.0848 × (1-0.3366) ×
0.11 + 0.12 × 0.02 + 0.2 × 0.87
= 0.1825, or 18.25%
McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved
- 30. 17- 30
Web Resources
Click to access web sites
Internet connection required
www.finance.yahoo.com/
www.valuepro.net
McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved
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