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 Does Debt Policy Matter? Principles of Corporate Finance Brealey and Myers Sixth Edition Slides by Matthew Will Chapter 17 © The McGraw-Hill Companies,

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Presentation on theme: " Does Debt Policy Matter? Principles of Corporate Finance Brealey and Myers Sixth Edition Slides by Matthew Will Chapter 17 © The McGraw-Hill Companies,"— Presentation transcript:

1  Does Debt Policy Matter? Principles of Corporate Finance Brealey and Myers Sixth Edition Slides by Matthew Will Chapter 17 © The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill

2 © The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill Topics Covered  Leverage in a Tax Free Environment  How Leverage Effects Returns  The Traditional Position

3 © The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill 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.

4 © The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill 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

5 © The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill Example - Macbeth Spot Removers - All Equity Financed M&M (Debt Policy Doesn’t Matter) Expected outcome

6 © The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill Example cont. 50% debt M&M (Debt Policy Doesn’t Matter)

7 © The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill Example - Macbeth’s - All Equity Financed - Debt replicated by investors M&M (Debt Policy Doesn’t Matter)

8 © The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill 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

9 © The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill Proposition I and Macbeth Macbeth continued

10 © The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill Leverage and Returns

11 © The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill M&M Proposition II Macbeth continued

12 © The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill M&M Proposition II Macbeth continued

13 © The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill r DEDE rDrD rErE M&M Proposition II rArA Risk free debtRisky debt

14 © The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill Leverage and Risk Macbeth continued Leverage increases the risk of Macbeth shares

15 © The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill Leverage and Returns

16 © The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill WACC  WACC is the traditional view of capital structure, risk and return.

17 © The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill WACC.10=r D.20=r E.15=r A BEBE BABA BDBD Risk Expected Return Equity All assets Debt

18 © The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill WACC Example - A firm has $2 mil of debt and 100,000 of outstanding shares at $30 each. If they can borrow at 8% and the stockholders require 15% return what is the firm’s WACC? D = $2 million E = 100,000 shares X $30 per share = $3 million V = D + E = = $5 million

19 © The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill WACC Example - A firm has $2 mil of debt and 100,000 of outstanding shares at $30 each. If they can borrow at 8% and the stockholders require 15% return what is the firm’s WACC? D = $2 million E = 100,000 shares X $30 per share = $3 million V = D + E = = $5 million

20 © The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill r DVDV rDrD rErE r E =WACC WACC

21 © The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill r DVDV rDrD rErE WACC WACC (traditional view)

22 © The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill r DVDV rDrD rErE WACC WACC (M&M view)


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