Principles of Corporate Finance Brealey, Myers, Partington and Robinson 1st Australian Edition Does Debt Policy Matter? Slides by Matthew Will and Graham Partington Irwin/McGraw Hill Chapter 17 ©2000 McGraw-Hill Book Company Australia Pty Ltd PPT t/a Principles of Corporate Finance by Brealey et al 17- Topics Covered Cost of capital and WACC Leverage in a Tax Free Environment How Leverage Influences Returns The Traditional Position Irwin/McGraw Hill ©2000 McGraw-Hill Book Company Australia Pty Ltd PPT t/a Principles of Corporate Finance by Brealey et al 17- Cost of Equity The cost of equity is the return required by equity investors, given the risk of the cash flows from the firm There are two major methods for determining the cost of equity Dividend growth model SML or CAPM Irwin/McGraw Hill ©2000 McGraw-Hill Book Company Australia Pty Ltd PPT t/a Principles of Corporate Finance by Brealey et al 17- The Dividend Growth Model Approach Start with the dividend growth model formula and rearrange to solve for RE D1 P0 = RE − g RE Irwin/McGraw Hill D1 = + g P0 ©2000 McGraw-Hill Book Company Australia Pty Ltd PPT t/a Principles of Corporate Finance by Brealey et al Dividend Growth Model Example 17- Suppose that your company is expected to pay a dividend of $1.50 per share next year There has been a steady growth in dividends of 5.1% per year and the market expects that to continue The current price is $25 What is the cost of equity? 50 RE = + 051 = 111 = 11 % 25 Irwin/McGraw Hill ©2000 McGraw-Hill Book Company Australia Pty Ltd PPT t/a Principles of Corporate Finance by Brealey et al 17- Example: Estimating the Dividend Growth Rate One method for estimating the growth rate is to use the historical average Year Dividend Percent Change 2000 1.23 (1.30 – 1.23) / 1.23 = 5.7% 2001 1.30 (1.36 – 1.30) / 1.30 = 4.6% 2002 1.36 (1.43 – 1.36) / 1.36 = 5.1% 2003 1.43 (1.50 – 1.43) / 1.43 = 4.9% 2004 1.50 Average = (5.7 + 4.6 + 5.1 + 4.9) / = 5.1% Irwin/McGraw Hill ©2000 McGraw-Hill Book Company Australia Pty Ltd PPT t/a Principles of Corporate Finance by Brealey et al 17- Advantages and Disadvantages of Dividend Growth Model Advantage – easy to understand and use Disadvantages Only applicable to companies currently paying dividends Not applicable if dividends aren’t growing at a reasonably constant rate Extremely sensitive to the estimated growth rate – an increase in g of 1% increases the cost of equity by 1% Does not explicitly consider risk Irwin/McGraw Hill ©2000 McGraw-Hill Book Company Australia Pty Ltd PPT t/a Principles of Corporate Finance by Brealey et al 17- Cost of Debt The cost of debt is the required return on company’s debt Usually focus on the cost of long-term debt or bonds The required return is best estimated by computing the yield-to-maturity on the existing debt We may also use estimates of current rates based on the bond rating we expect when we issue new debt The cost of debt is NOT the coupon rate Irwin/McGraw Hill ©2000 McGraw-Hill Book Company Australia Pty Ltd PPT t/a Principles of Corporate Finance by Brealey et al 17- Example: Cost of Debt Suppose we have a bond issue currently outstanding that has 25 years left to maturity The coupon rate is 9% and coupons are paid semiannually The bond is currently selling for $908.72 per $1000 bond What is the cost of debt? N = 50; PMT = 45; FV = 1000; PV = -908.75; CPT I/Y = 5%; YTM = 5(2) = 10% Irwin/McGraw Hill ©2000 McGraw-Hill Book Company Australia Pty Ltd PPT t/a Principles of Corporate Finance by Brealey et al 17- 10 Cost of Preferred Stock Reminders Preferred stock generally pays a constant dividend each period Dividends are expected to be paid every period forever Preferred stock is a perpetuity, so we take the perpetuity formula, rearrange and solve for RP RP = D / P0 Irwin/McGraw Hill ©2000 McGraw-Hill Book Company Australia Pty Ltd PPT t/a Principles of Corporate Finance by Brealey et al 10 17- 23 M&M (Debt Policy Doesn’t Matter) Example cont 50% debt Data Number of shares Price per share 500 $10 Market Value of Shares $ 5,000 Market value of debt $ 5,000 Outcomes A Irwin/McGraw Hill B C D Operating Income Interest $500 1,000 1,500 2,000 $500 500 500 500 Equity earnings Earnings per share $0 $0 500 1,000 1,500 Return on shares (%) 0% 15 20 30 ©2000 McGraw-Hill Book Company Australia Pty Ltd PPT t/a Principles of Corporate Finance by Brealey et al 23 17- 24 M&M (Debt Policy Doesn’t Matter) Example - Macbeth’s Outcomes - All Equity Financed - Debt replicated by investors Who borrow to finance 50% of their share investment A B C D Earnings on two shares LESS : Interest @ 10% Net earnings on investment $1.00 2.00 3.00 4.00 $1.00 1.00 1.00 1.00 $0 1.00 2.00 3.00 Return on $10 investment (%) 0% Irwin/McGraw Hill 10 20 30 ©2000 McGraw-Hill Book Company Australia Pty Ltd PPT t/a Principles of Corporate Finance by Brealey et al 24 17- 25 No Magic in Financial Leverage MM'S PROPOSITION I If capital markets are perfect, firms cannot increase value by tinkering with capital structure V is independent of the debt ratio The sum of the parts is equal to the whole VU = VL = E + D Irwin/McGraw Hill ©2000 McGraw-Hill Book Company Australia Pty Ltd PPT t/a Principles of Corporate Finance by Brealey et al 25 17- 26 Proposition I and Required Returns Macbeth continued Cuttent Structure : Proposed Structure : Expected earnings per share ($) All Equity 1.50 Equal Debt and Equity 2.00 Price per share ($) 10 10 Expected return per share (%) 15 20 Assuming equilibrium expected and required returns are equal Irwin/McGraw Hill ©2000 McGraw-Hill Book Company Australia Pty Ltd PPT t/a Principles of Corporate Finance by Brealey et al 26 17- 27 Leverage and Returns expected operating income Expected return on assets = = market value of all securities Expected return on assets equals the expected return on the firm’s portfolio of issued securities D E rA = rP = × rD + × rE D+E D+E Irwin/McGraw Hill ©2000 McGraw-Hill Book Company Australia Pty Ltd PPT t/a Principles of Corporate Finance by Brealey et al 27 17- 28 M&M Proposition II By re-arrangement of the last equation: Macbeth continued D rE = rA + (rA − rD ) E When Macbeth is all equity: expected operating income rE = rA = market value of all securities 1500 = = 15 10,000 Irwin/McGraw Hill ©2000 McGraw-Hill Book Company Australia Pty Ltd PPT t/a Principles of Corporate Finance by Brealey et al 28 17- 29 M&M Proposition II D rE = rA + (rA − rD ) E Macbeth continued expected operating income rE = rA = market value of all securities 1500 = = 15 10,000 5000 (.15 − 10) rE = 15 + 5000 = 20 or 20% Irwin/McGraw Hill ©2000 McGraw-Hill Book Company Australia Pty Ltd PPT t/a Principles of Corporate Finance by Brealey et al 29 17- 30 M&M Proposition II r rE rA rD Risk free debt Irwin/McGraw Hill Risky debt D E ©2000 McGraw-Hill Book Company Australia Pty Ltd PPT t/a Principles of Corporate Finance by Brealey et al 30 17- 31 Leverage and Risk Macbeth continued Leverage increases the risk of Macbeth shares Operating Income All equity Earnings per share ($) Return on shares 50 % debt : Earnings per share ($) Return on shares Irwin/McGraw Hill $500 $1,500 50 1.50 15 20 ©2000 McGraw-Hill Book Company Australia Pty Ltd PPT t/a Principles of Corporate Finance by Brealey et al 31 17- 32 Leverage and Risk By analogy with the return equation: D E βA = × βD + × βE D+E D+E D β E = β A + (β A − β D ) E Irwin/McGraw Hill ©2000 McGraw-Hill Book Company Australia Pty Ltd PPT t/a Principles of Corporate Finance by Brealey et al 32 17- 33 Returns and Beta Required Return 20=rE Equity 15=rA All assets 10=rD Debt Risk BD Irwin/McGraw Hill BA BE ©2000 McGraw-Hill Book Company Australia Pty Ltd PPT t/a Principles of Corporate Finance by Brealey et al 33 17- 34 The Traditional Position and WACC WACC is the basis for the traditional view of capital structure, risk and return D E WACC = rA = × rD + × rE V V DANGER: Handle WACC with care The objective is NOT to minimise WACC If D/V changes rE changes too Irwin/McGraw Hill ©2000 McGraw-Hill Book Company Australia Pty Ltd PPT t/a Principles of Corporate Finance by Brealey et al 34 17- 35 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 shareholders 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 ©2000 McGraw-Hill Book Company Australia Pty Ltd PPT t/a Principles of Corporate Finance by Brealey et al 35 17- 36 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 shareholders 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 D E WACC = × rD + × rE V V 2 3 = × 08 + × 15 5 5 = 122 or 12.2% ©2000 McGraw-Hill Book Company Australia Pty Ltd Irwin/McGraw Hill PPT t/a Principles of Corporate Finance by Brealey et al 36 17- 37 Traditional Position and WA r Assuming rE is invariant to leverage: rE rA =WACC Absurd! rD D V Irwin/McGraw Hill ©2000 McGraw-Hill Book Company Australia Pty Ltd PPT t/a Principles of Corporate Finance by Brealey et al 37 ... PROPOSITION: DEBT POLICY DOESN’T MATTER Irwin/McGraw Hill ©2000 McGraw-Hill Book Company Australia Pty Ltd PPT t/a Principles of Corporate Finance by Brealey et al 19 17- 20 M&M (Debt Policy Doesn’t Matter) ... Brealey et al 22 17- 23 M&M (Debt Policy Doesn’t Matter) Example cont 50% debt Data Number of shares Price per share 500 $10 Market Value of Shares $ 5,000 Market value of debt $ 5,000 Outcomes A... t/a Principles of Corporate Finance by Brealey et al 20 17- 21 M&M (Debt Policy Doesn’t Matter) Assumptions Capital structure does not affect cash flows e.g No taxes No bankruptcy costs No effect