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**The McGraw-Hill Companies, Inc., 2000**

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

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**Topics Covered Leverage in a Tax Free Environment**

How Leverage Effects Returns The Traditional Position

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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)**

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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**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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M&M Proposition II r rE rA rD D E Risk free debt Risky debt 9

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**Leverage and Risk Macbeth continued**

Leverage increases the risk of Macbeth shares

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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 Expected Return .20=rE .15=rA .10=rD Risk BD BA BE Equity**

All assets .10=rD Debt Risk BD BA BE

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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

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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

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WACC r rE rE =WACC rD D V 8

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**WACC (traditional view)**

rE WACC rD D V 8

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WACC (M&M view) r rE WACC rD D V 9

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