Chapter 18

Principles
of
Corporate
Finance

Ninth Edition
Does Debt Policy
Matter?
Slides by
Matthew Will
Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved McGraw Hill/Irwin
Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved
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Topics Covered
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

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M&M (Debt Policy Doesnt 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.
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M&M (Debt Policy Doesnt 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
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M&M (Debt Policy Doesnt Matter)
Profits 01 . 01V .
urn Dollar Ret Investment Dollar
U

L
L L
L
L
01V .
Profits 01 . ) E 01(D . Total
Interest) - Profits ( 01 . 01E . Equity
Interest .01 01D . Debt
urn Dollar Ret Investment Dollar
=
+


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M&M (Debt Policy Doesnt Matter)
) .01(V
interest) - Profits ( 01 . 01E .
urn Dollar Ret Investment Dollar
L L
L
D =

Interest) - Profits ( 01 . ) D 01(V . Total
Profits 01 . 01V . Equity
Interest .01 - 01D . Borrowing
urn Dollar Ret Investment Dollar
L U
U
L
+


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Example - Macbeth Spot Removers - All Equity Financed
20 15 10 % 5 (%) shares on Return
2.00 1.50 1.00 $.50 share per Earnings
2,000 1,500 1,000 $500 Income Operating
D C B A
Outcomes
10,000 $ Shares of Value Market
$10 share per Price
1,000 shares of Number
Data
M&M (Debt Policy Doesnt Matter)
Expected
outcome
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Example
cont.
50% debt
M&M (Debt Policy Doesnt Matter)
30 20 10 0% (%) shares on Return
3 2 1 $0 share per Earnings
500 , 1 1,000 500 $0 earnings Equity
500 500 500 $500 Interest
000 , 2 1,500 1,000 $500 Income Operating
C B A
Outcomes
5,000 $ debt of ue Market val
5,000 $ Shares of Value Market
$10 share per Price
500 shares of Number
Data
D
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Example - Macbeths - All Equity Financed
- Debt replicated by investors
30 20 10 0% (%) investment $10 on Return
3.00 2.00 1.00 0 $ investment on earnings Net
1.00 1.00 1.00 $1.00 10% @ Interest : LESS
4.00 3.00 2.00 $1.00 shares two on Earnings
D C B A
Outcomes
M&M (Debt Policy Doesnt Matter)
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Borrowing and EPS at Macbeth
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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
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Proposition I and Macbeth
20 15 (%) share per return Expected
10 10 ($) share per Price
2.00 1.50 ($) share per earnings Expected
Equity and Debt Equal
: Structure Proposed
Equity All
: Structure Cuttent
Macbeth continued
Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved
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Leverage and Returns
securities all of ue market val
income operating expected
r assets on return Expected
a
= =
|
.
|

\
|
+
+
|
.
|

\
|
+
=
E D
E
r
E D
D
r r
E D A
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M&M Proposition II
15 .
000 , 10
1500
securities all of ue market val
income operating expected
r r
A E
= =
= =
( )
E
D
r r r r
D A A E
+ =
Macbeth continued
Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved
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M&M Proposition II
( )
E
D
r r r r
D A A E
+ =
15 .
000 , 10
1500
securities all of ue market val
income operating expected
r r
A E
= =
= =
( )
20% or 20 .
5000
5000
10 . 15 . 15 .
=
+ =
E
r
Macbeth continued
Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved
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Leverage and Risk
20% - 0 20% shares on Return
$2.00 - 0 2 ($) share per Earnings : debt % 50
10% - 5% 15% shares on Return
$1.00 - 0.50 1.50 ($) share per Earnings equity All
Change
$500
Income
to $1,500
Operating
Macbeth continued
Leverage increases the risk of Macbeth shares
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Leverage and Returns
% 75 . 12
100
60
15 .
100
40
075 . =
|
.
|

\
|
+
|
.
|

\
|
=
|
.
|

\
|
+
+
|
.
|

\
|
+
=
A
E D A
r
E D
E
r
E D
D
r r
Asset Value 100 Debt (D) 40
Equity (E) 60
Asset Value 100 Firm Value (V) 100

r
d
= 7.5%
r
e
= 15%

Market Value Balance Sheet example
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Leverage and Returns
% 0 . 16
100
60
100
40
07875 . 1275 .
=
|
.
|

\
|
+
|
.
|

\
|
=
e
e
r
r
Asset Value 100 Debt (D) 40
Equity (E) 60
Asset Value 100 Firm Value (V) 100

r
d
= 7.5% changes to 7.875%
r
e
= ??

Market Value Balance Sheet example continued
What happens to Re when debt costs rise?
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Leverage and Returns
|
.
|

\
|
+
|
.
|

\
|
=
V
E
B
V
D
B B
E D A
( )
D A A E
B B
V
D
B B + =
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WACC
|
.
|

\
|
+
|
.
|

\
|
= =
V
E
r
V
D
r r WACC
E D A
WACC is the traditional view of capital
structure, risk and return.
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r
D
V
r
D
r
E
r
E
=WACC
WACC
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r
D
E
r
D
r
E
M&M Proposition II
r
A
Risk free debt Risky debt
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r
D
V
r
D
r
E
WACC
WACC (traditional view)
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r
D
V
r
D
r
E
WACC
WACC (M&M 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.
|
.
|

\
|
+
|
.
|

\
|
=
V
E
r
V
D
r WACC
E D
Old Formula
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McGraw Hill/Irwin
After Tax WACC
|
.
|

\
|
+
|
.
|

\
|
=
V
E
r
V
D
Tc r WACC
E D
) 1 (
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 12.0% and
the pretax cost of debt is 6.0%. 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
Balance Sheet (Market Value, billions)
Assets 32.9 6.7 Debt
26.2 Equity
Total assets 32.9 32.9 Total liabilities
MARKET VALUES
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After Tax WACC
Example - Union Pacific - continued
|
.
|

\
|
+
|
.
|

\
|
=
V
E
r
V
D
Tc r WACC
E D
) 1 (
Debt ratio = (D/V) = 6.7/32.9= .20 or 20%

Equity ratio = (E/V) = 26.2/32.9 = .80 or 80%
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After Tax WACC
Example - Union Pacific - continued
|
.
|

\
|
+
|
.
|

\
|
=
V
E
r
V
D
Tc r WACC
E D
) 1 (
( ) ( )
% 4 . 10
104 .
80 . 12 . 20 . ) 35 . 1 ( 06 .
=
=
+ = WACC
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After Tax WACC
Another Example - Kates Cafe

Kates Caf 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 - Kates Cafe- continued
Balance Sheet (Market Value, billions)
Assets 22.6 7.6 Debt
15 Equity
Total assets 22.6 22.6 Total liabilities
MARKET VALUES
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After Tax WACC
Another Example - Kates Cafe- continued
|
.
|

\
|
+
|
.
|

\
|
=
V
E
r
V
D
Tc r WACC
E D
) 1 (
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 - Kates Cafe- continued

|
.
|

\
|
+
|
.
|

\
|
=
V
E
r
V
D
Tc r WACC
E D
) 1 (
( ) ( )
% 8 . 7
078 .
66 . 10 . 34 . ) 35 . 1 ( 055 .
=
=
+ = WACC
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