Debt policy 50 years hence…we shall escape the absurdity of growing a whole chicken in order to eat the breast or wing, by growing these parts separately under a suitable medium – Winston Churchill 1932

No magic in financial leverage M&M'S PROPOSITION I If capital markets are doing their job, firms cannot increase value by tinkering with capital structure. Value is independent of the debt ratio. A GROCERY STORE ANALOGY It should cost no more to assemble a chicken than to buy one whole chicken.

Implications of No magic in leverage Company cost of capital is independent of leverage. Company cost of capital = expected return on all securities Company cost of = capital

Beta of Assets

In perfect markets the increase in expected EPS is exactly offset by the fall in P/E Share price Log scale P/E ratio Expected EPS Debt ratio

Assumptions behind irrelevance argument 1. 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 matters if firm can offer a new financial service that meets the needs of some clientele. 2. Capital structure does not affect cash flows assuming: No taxes No bankruptcy costs No effect on management incentives

Debt Increases Expected Rate of Return MM'S PROPOSITION II The rate of return shareholders can expect to receive on their shares increases as the firms debt ratio increases. How can shareholders be indifferent to increased leverage if it increases their expected return? Any increase in expected return is offset by increases in risk and therefore the shareholders required rate of return.

M&M Proposition II

M&Ms proposition does not hold in the grocery store TWO REASONS: 1.Demand side Consumers are willing to pay extra to pick and choose the pieces they like. 2.Supply side It is costly for supermarkets to cut up the chickens and sell the pieces separately

Marketing the firms assets as a package of financial claims M&Ms proposition I is violated when the firm can offer some financial service to investors. The service must be unique, or the firm must be able to provide it more cheaply. Thus you need an unsatisfied clientele. Is there an unsatisfied clientele for straight corporate debt? Probably not, but you may be able to think of some unusual financial claim.

After Tax WACC Tax Adjusted Formula

After Tax WACC Example - Union Pacific MARKET VALUES

After Tax WACC Example - Union Pacific The firm has a marginal tax rate of 35%. The cost of equity is 12.0% and the pretax cost of debt is 6.0%. Given the market value balance sheet, what is the tax adjusted WACC?

After Tax WACC Example - Union Pacific - continued

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 market value balance sheet on next slide, what is the tax adjusted WACC?

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

After Tax WACC Another Example - Kates Cafe- continued