Chapter

17
Does Debt Policy
Matter?
Slides by
Matthew Will
McGraw-Hill/Irwin Copyright 2011 by the McGraw-Hill Companies, Inc. ll rights reser!e".
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

M&M !e"t #olic$ !oesn%t Matter&

Modigliani & Miller

When there are no taxes and capital markets

function 'ell( it makes no difference 'hether
the firm "orro's or individual shareholders
"orro') Therefore( the market value of a
compan$ does not depend on its capital
structure)
M&M !e"t #olic$ !oesn%t Matter&
Assumptions

*$ issuing + securit$ rather than ,( compan$

diminishes investor choice) This does not reduce
value if-

.nvestors do not need choice( /R

There are sufficient alternative securities

Capital structure does not affect cash flo's e)g)))

0o taxes

0o "ankruptc$ costs

0o effect on management incentives

M&M !e"t #olic$ !oesn%t 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 . Det
Return Dollar Investment Dollar
=
+

M&M !e"t #olic$ !oesn%t 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 . !orro"in#
urn Dollar Ret Investment Dollar
L U
U
L
+

Example 1 Mac"eth 2pot Removers 1 All E3uit$
Financed
MM !Debt Policy Doesn"t Matter#
E$%e&te'
out&ome
(0 1) 10 * ) (*) s+ares on Return
(.00 1.)0 1.00 ,.)0 s+are %er Earnin#s
(-000 1-)00 1-000 ,)00 In&ome .%eratin#
D / ! 0
.ut&omes
10-000 , 1+ares of Value 2ar3et
,10 s+are %er Pri&e
1-000 s+ares of 4umer
Data
Example
cont)
456 de"t
MM !Debt Policy Doesn"t Matter#
30 20 10 0# $#% shares on &et'rn
5 ( 1 ,0 s+are %er Earnin#s
)00 - 1 1-000 )00 ,0 earnin#s Equity
)00 )00 )00 ,)00 Interest
000 - ( 1-)00 1-000 ,)00 In&ome .%eratin#
/ ! 0
.ut&omes
)-000 , 'et of ue 2ar3et val
)-000 , 1+ares of Value 2ar3et
,10 s+are %er Pri&e
)00 s+ares of 4umer
Data
D
Example 1 Mac"eth%s 1 All E3uit$ Financed
1 !e"t replicated "$ investors
MM !Debt Policy Doesn"t Matter#
(0 20 10 0# $#% in!estment )10 on &et'rn
5.00 (.00 1.00 0 , investment on earnin#s 4et
1.00 1.00 1.00 ,1.00 10* 6 Interest 7 LE11
8.00 5.00 (.00 ,1.00 s+ares t"o on Earnin#s
D / ! 0
.ut&omes
$orrowin% and EPS at Macbeth
MM72 #R/#/2.T./0 .
.f capital markets are doing their 8o"(
firms cannot increase value "$ tinkering
'ith capital structure)
9 is independent of the de"t ratio)
A0 E9ER:!A: A0AL/;:
.t should cost no more to assem"le a
chicken than to "u$ one 'hole)
0o Magic in Financial Leverage
#roposition . and Mac"eth
Macbeth contin'e"
(0 1) (*) s+are %er return E$%e&te'
10 10 (,) s+are %er Pri&e
(.00 1.)0 (,) s+are %er earnin#s E$%e&te'
Equity an' Det Equal
7 1tru&ture Pro%ose'
Equity 0ll
7 1tru&ture /uttent
Leverage and Returns
se&urities all of ue mar3et val
in&ome o%eratin# e$%e&te'
r assets on return E$%e&te'
a
= =

+
+

+
=
E D A
r
E D
E
r
E D
D
r
M&M #roposition ..
Macbeth contin'e"
1) .
000 - 10
1)00
se&urities all of ue mar3et val
in&ome o%eratin# e$%e&te'
r r
0 E
= =
= =
( )
E
D
r r r r
D A A E
+ =
M&M #roposition ..
Macbeth contin'e"
( )
E
D
r r r r
D A A E
+ =
1) .
000 - 10
1)00
se&urities all of ue mar3et val
in&ome o%eratin# e$%e&te'
r r
0 E
= =
= =
( )
(0* or (0 .
)000
)000
10 . 1) . 1) .
=
+ =
E
r
Leverage and Risk
Macbeth contin'e"
Levera#e in&reases t+e ris3 of 2a&et+ s+ares
(0* - 0 (0* s+ares on Return
,(.00 - 0 ( (,) s+are %er Earnin#s 7 'et * )0
10* - )* 1)* s+ares on Return
,1.00 - 0.)0 1.)0 (,) s+are %er Earnin#s equity 0ll
/+an#e
,)00
In&ome
to ,1-)00
.%eratin#
Leverage and Returns
0sset Value 100 Det (D) 80
Equity (E) 90
0sset Value 100 :irm Value (V) 100
r' ; <.)*
re ; 1)*
2ar3et Value !alan&e 1+eet e$am%le
* <) . 1(
100
90
1) .
100
80
0<) . =

+
+

+
=
A
E D A
r
E D
E
r
E D
D
r r
Leverage and Returns
0sset Value 100 Det (D) 80
Equity (E) 90
0sset Value 100 :irm Value (V) 100
r' ; <.)* &+an#es to <.=<)*
re ; >>
2ar3et Value !alan&e 1+eet e$am%le ? &ontinue'
@+at +a%%ens to Re "+en 'et &osts rise>
* 0 . 19
100
90
100
80
0<=<) . 1(<) .
=

=
e
e
r
r
Leverage and Returns

=
V
E
B
V
D
B B
E D A
( )
D A A E
B B
V
D
B B + =
WACC

@0// is t+e tra'itional vie" of &a%ital

stru&ture- ris3 an' return.

= =
V
E
r
V
D
r r WACC
E D A
M&M #roposition ..
WACC traditional vie'&