2Topics CoveredFinancial Leverage in a Competitive Tax Free EnvironmentFinancial Risk and Expected ReturnsThe Weighted Average Cost of CapitalA Final Word on After Tax WACC222232
3M&M (Debt Policy Doesn’t Matter) Modigliani & MillerWhen 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.3
4M&M (Debt Policy Doesn’t Matter) AssumptionsBy issuing 1 security rather than 2, company diminishes investor choice. This does not reduce value if:Investors do not need choice, ORThere are sufficient alternative securitiesCapital structure does not affect cash flows e.g...No taxesNo bankruptcy costsNo effect on management incentives4
11No Magic in Financial Leverage MM'S PROPOSITION IIf capital markets are doing their job,firms cannot increase value by tinkeringwith capital structure.V is independent of the debt ratio.AN EVERYDAY ANALOGYIt should cost no more to assemble achicken than to buy one whole.
16Leverage and Risk Macbeth continued Leverage increases the risk of Macbeth shares
17Market Value Balance Sheet example Leverage and ReturnsMarket Value Balance Sheet exampleAsset Value 100 Debt (D) 30Equity (E) 70Asset Value 100 Firm Value (V) 100rd = 7.5%re = 15%
18Market Value Balance Sheet example – continued Leverage and ReturnsMarket Value Balance Sheet example – continuedWhat happens to Re when the amount of debt is increased?Asset Value 100 Debt (D) 40Equity (E) 60Asset Value 100 Firm Value (V) 100rd = 7.5% changes to 7.875%re = ??
24After Tax WACCThe 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
26After 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?
27After Tax WACCExample - Union Pacific - continuedMARKET VALUES
28After 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%
29After Tax WACCExample - Union Pacific - continued
31After Tax WACC Another Example - Kate’s Cafe Kate’s 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?
32After Tax WACCAnother Example - Kate’s Cafe- continuedMARKET VALUES
33After Tax WACC Another Example - Kate’s Cafe- continued Debt ratio = (D/V) = 7.6/22.6= .34 or 34%Equity ratio = (E/V) = 15/22.6 = .66 or 66%
34After Tax WACCAnother Example - Kate’s Cafe- continued
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