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**Does Debt Policy Matter?**

Principles of Corporate Finance Tenth Edition Chapter 17 Does Debt Policy Matter? Slides by Matthew Will McGraw-Hill/Irwin Copyright © 2011 by the McGraw-Hill Companies, Inc. All rights reserved. 1 1 1 1 1 2

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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 2 2 2 2 3 2

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**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. 3

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**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 4

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**M&M (Debt Policy Doesn’t Matter)**

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**M&M (Debt Policy Doesn’t Matter)**

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**M&M (Debt Policy Doesn’t Matter)**

Example - Macbeth Spot Removers - All Equity Financed Expected outcome 5

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**M&M (Debt Policy Doesn’t Matter)**

Example cont. 50% debt 6

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**M&M (Debt Policy Doesn’t Matter)**

Example - Macbeth’s All Equity Financed - Debt replicated by investors 7

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**Borrowing and EPS at Macbeth**

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**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.

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**Proposition I and Macbeth**

Macbeth continued

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Leverage and Returns

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M&M Proposition II Macbeth continued

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M&M Proposition II Macbeth continued

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**Leverage and Risk Macbeth continued**

Leverage increases the risk of Macbeth shares

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**Market Value Balance Sheet example**

Leverage and Returns Market Value Balance Sheet example Asset Value 100 Debt (D) 30 Equity (E) 70 Asset Value 100 Firm Value (V) 100 rd = 7.5% re = 15%

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**Market Value Balance Sheet example – continued**

Leverage and Returns Market Value Balance Sheet example – continued What happens to Re when the amount of debt is increased? Asset Value 100 Debt (D) 40 Equity (E) 60 Asset Value 100 Firm Value (V) 100 rd = 7.5% changes to 7.875% re = ??

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Leverage and Returns

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

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WACC r rE rA = WACC rD D V 8

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M&M Proposition II 9

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**WACC (traditional view)**

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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

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After Tax WACC Tax Adjusted Formula

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**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?

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After Tax WACC Example - Union Pacific - continued MARKET VALUES

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**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%

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After Tax WACC Example - Union Pacific - continued

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Union Pacific WACC 9

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**After 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?

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After Tax WACC Another Example - Kate’s Cafe- continued MARKET VALUES

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**After 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%

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After Tax WACC Another Example - Kate’s Cafe- continued

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**Web Resources Click to access web sites Internet connection required**

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