Principles of Corporate Finance Brealey and Myers Sixth Edition Does Debt Policy Matter? Slides by Matthew Will Irwin/McGraw Hill Chapter 17 ©The McGraw-Hill Companies, Inc., 200 17- Topics Covered Leverage in a Tax Free Environment How Leverage Effects Returns The Traditional Position Irwin/McGraw Hill ©The McGraw-Hill Companies, Inc., 200 17- 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 Irwin/McGraw Hill ©The McGraw-Hill Companies, Inc., 200 17- M&M (Debt Policy Doesn’t Matter) Assumptions By issuing security rather than 2, company diminishes investor choice This does not reduce value if: Investors 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 Irwin/McGraw Hill ©The McGraw-Hill Companies, Inc., 200 17- M&M (Debt Policy Doesn’t Matter) Example - Macbeth Spot Removers - All Equity Financed Data Number of shares Price per share 1,000 $10 Market Value of Shares $ 10,000 Outcomes A B C D Operating Income $500 1,000 1,500 2,000 Earnings per share Return on shares (%) $.50 5% Irwin/McGraw Hill 1.00 10 1.50 15 2.00 20 Expected outcome ©The McGraw-Hill Companies, Inc., 200 17- M&M (Debt Policy Doesn’t Matter) Example cont 50% debt Data Number of shares Price per share Market Value of Shares Market value of debt 500 $10 $ 5,000 $ 5,000 Outcomes Operating Income Interest Equity earnings Earnings per share Return on shares (%) Irwin/McGraw Hill A $500 $500 $0 $0 0% B 1,000 500 500 15 C 1,500 500 1,000 25 D 2,000 500 1,500 30 ©The McGraw-Hill Companies, Inc., 200 17- M&M (Debt Policy Doesn’t Matter) Example - Macbeth’s - All Equity Financed - Debt replicated by investors Outcomes A B C D Earnings on two shares $1.00 2.00 3.00 4.00 LESS : Interest @ 10% $1.00 1.00 1.00 1.00 Net earnings on investment $0 1.00 2.00 3.00 Return on $10 investment (%) 0% 10 Irwin/McGraw Hill 20 30 ©The McGraw-Hill Companies, Inc., 200 17- No Magic in Financial Leverage MM'S PROPOSITION I If capital markets are doing their job, firms cannot increase value by tinkering with capital structure V is independent of the debt ratio AN EVERYDAY ANALOGY It should cost no more to assemble a chicken than to buy one whole Irwin/McGraw Hill ©The McGraw-Hill Companies, Inc., 200 17- Proposition I and Macbeth Macbeth continued Expected earnings per share ($) Price per share ($) Expected return per share (%) Irwin/McGraw Hill Cuttent Structure : Proposed Structure : All Equity Equal Debt and Equity 1.50 2.00 10 10 15 20 ©The McGraw-Hill Companies, Inc., 200 17- 10 Leverage and Returns expected operating income Expected return on assets ra market value of all securities D E rA rD rE DA DE Irwin/McGraw Hill ©The McGraw-Hill Companies, Inc., 200 17- 11 M&M Proposition II D rE rA rA rD V Macbeth continued expected operating income rE rA market value of all securities 1500 .15 10,000 Irwin/McGraw Hill ©The McGraw-Hill Companies, Inc., 200 17- 12 M&M Proposition II D rE rA rA rD V Macbeth continued expected operating income market value of all securities 1500 .15 10,000 rE rA 5000 .15 10 rE .15 5000 .20 or 20% Irwin/McGraw Hill ©The McGraw-Hill Companies, Inc., 200 17- 13 M&M Proposition II r rE rA rD Risk free debt Irwin/McGraw Hill Risky debt D E ©The McGraw-Hill Companies, Inc., 200 17- 14 Leverage and Risk Macbeth continued Leverage increases the risk of Macbeth shares All Allequity equity Earnings Earningsper pershare share($) ($) Return Returnon onshares shares 50 50% %debt debt:: Earnings Earningsper pershare share($) ($) Return Returnon onshares shares Irwin/McGraw Hill Operating Operating $500 $500 50 50 55 00 Income Income $1,500 $1,500 1.50 1.50 15 15 22 00 20 20 ©The McGraw-Hill Companies, Inc., 200 17- 15 Leverage and Returns DD EE BBAA BBDD BBEE DD AA DDEE DD BBEE BBAA BBAA BBDD VV Irwin/McGraw Hill ©The McGraw-Hill Companies, Inc., 200 17- 16 WACC WACC is the traditional view of capital structure, risk and return DD EE WACC WACC rrAA rrDD rrEE VV VV Irwin/McGraw Hill ©The McGraw-Hill Companies, Inc., 200 17- 17 WACC Expected Return 20=rE Equity 15=rA All assets 10=rD Debt BD Irwin/McGraw Hill BA BE Risk ©The McGraw-Hill Companies, Inc., 200 17- 18 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 Irwin/McGraw Hill ©The McGraw-Hill Companies, Inc., 200 17- 19 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 DD EE WACC WACC V rrDDV rrEE V V 22 33 .08 15 .15 08 55 55 .122 122 or or 12.2% 12.2% Irwin/McGraw Hill ©The McGraw-Hill Companies, Inc., 200 17- 20 WACC r rE rE =WACC rD D V Irwin/McGraw Hill ©The McGraw-Hill Companies, Inc., 200 17- 21 WACC (traditional view) r rE WACC rD D V Irwin/McGraw Hill ©The McGraw-Hill Companies, Inc., 200 17- 22 WACC (M&M view) r rE WACC rD D V Irwin/McGraw Hill ©The McGraw-Hill Companies, Inc., 200 ... Companies, Inc., 200 17- M&M (Debt Policy Doesn’t Matter) Example - Macbeth Spot Removers - All Equity Financed Data Number of shares Price per share 1,000 $10 Market Value of Shares $ 10,000 Outcomes... McGraw-Hill Companies, Inc., 200 17- M&M (Debt Policy Doesn’t Matter) Example cont 50% debt Data Number of shares Price per share Market Value of Shares Market value of debt 500 $10 $ 5,000 $ 5,000... Inc., 200 17- 17 WACC Expected Return 20=rE Equity 15=rA All assets 10=rD Debt BD Irwin/McGraw Hill BA BE Risk ©The McGraw-Hill Companies, Inc., 200 17- 18 WACC Example - A firm has $2 mil of debt