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Chapter 17 Principles of Corporate Finance Tenth Edition Does Debt Policy Matter? Slides by Matthew Will McGraw-Hill/Irwin Copyright © 2011 by the McGraw-Hill.

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Presentation on theme: "Chapter 17 Principles of Corporate Finance Tenth Edition Does Debt Policy Matter? Slides by Matthew Will McGraw-Hill/Irwin Copyright © 2011 by the McGraw-Hill."— Presentation transcript:

1 Chapter 17 Principles of Corporate Finance Tenth Edition Does Debt Policy Matter? Slides by Matthew Will McGraw-Hill/Irwin Copyright © 2011 by the McGraw-Hill Companies, Inc. All rights reserved.

2 17-2 Topics Covered Financial 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

3 17-3 M&M (Debt Policy Doesnt 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.

4 17-4 M&M (Debt Policy Doesnt 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

5 17-5 M&M (Debt Policy Doesnt Matter)

6 17-6 M&M (Debt Policy Doesnt Matter)

7 17-7 Example - Macbeth Spot Removers - All Equity Financed M&M (Debt Policy Doesnt Matter) Expected outcome

8 17-8 Example cont. 50% debt M&M (Debt Policy Doesnt Matter)

9 17-9 Example - Macbeths - All Equity Financed - Debt replicated by investors M&M (Debt Policy Doesnt Matter)

10 17-10 Borrowing and EPS at Macbeth

11 17-11 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

12 17-12 Proposition I and Macbeth Macbeth continued

13 17-13 Leverage and Returns

14 17-14 M&M Proposition II Macbeth continued

15 17-15 M&M Proposition II Macbeth continued

16 17-16 Leverage and Risk Macbeth continued Leverage increases the risk of Macbeth shares

17 17-17 Leverage and Returns Asset Value100Debt (D)30 Equity (E)70 Asset Value100Firm Value (V)100 r d = 7.5% r e = 15% Market Value Balance Sheet example

18 17-18 Leverage and Returns Asset Value100Debt (D)40 Equity (E)60 Asset Value100Firm Value (V)100 r d = 7.5% changes to 7.875% r e = ?? Market Value Balance Sheet example – continued What happens to Re when the amount of debt is increased?

19 17-19 Leverage and Returns

20 17-20 WACC WACC is the traditional view of capital structure, risk and return.

21 17-21 r DVDV rDrD rErE r A = WACC WACC

22 17-22 M&M Proposition II

23 17-23 WACC (traditional view)

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. Old Formula

25 17-25 After Tax WACC Tax Adjusted Formula

26 17-26 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?

27 17-27 After Tax WACC Example - Union Pacific - continued MARKET VALUES

28 17-28 After Tax WACC Example - Union Pacific - continued Debt ratio = (D/V) = 63/200=.315 or 31.5% Equity ratio = (E/V) = 137/200 =.685 or 68.5%

29 17-29 After Tax WACC Example - Union Pacific - continued

30 17-30 Union Pacific WACC

31 17-31 After Tax WACC Another Example - Kates Cafe Kates Café has a marginal tax rate of 35%. The cost of equity is 10.0% and the pretax cost of debt is 5.5%. Given the book and market value balance sheets, what is the tax adjusted WACC?

32 17-32 After Tax WACC Another Example - Kates Cafe- continued MARKET VALUES

33 17-33 After Tax WACC Another Example - Kates Cafe- continued Debt ratio = (D/V) = 7.6/22.6=.34 or 34% Equity ratio = (E/V) = 15/22.6 =.66 or 66%

34 17-34 After Tax WACC Another Example - Kates Cafe- continued

35 17-35 Web Resources Click to access web sites Internet connection required


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