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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
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
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
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
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
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
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
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
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
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
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
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
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
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
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
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

                    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
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
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
17- 20


                       WACC
          r

                                                                  rE

                                  rE =WACC

     rD
                                                                            D
                                                                            V
McGraw-Hill/Irwin   Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved
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
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
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
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
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
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
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
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
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
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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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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