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    1. Principles of Corporate Finance Chapter 17 Eighth Edition Does Debt Policy Matter? Slides by Matthew WillMcGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved
    2. 17- 2 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 WACCMcGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved
    3. 17- 3 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.McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved
    4. 17- 4 M&M (Debt Policy Doesn’t 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 incentivesMcGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved
    5. 17- 5 M&M (Debt Policy Doesn’t Matter) Rupee Investment Rupee Return .01VU .01× Profits Rupee Investment Rupee Return Debt .01D L .01× Interest Equity .01E L .01× (Profits-Interest) Total .01(D L + E L ) .01× Profits = .01VLMcGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved
    6. 17- 6 M&M (Debt Policy Doesn’t Matter) Rupee Investment Rupee Return .01E L .01× (Profits-interest) = .01(VL − DL ) Rupee Investment Rupee Return Borrowing −.01D L -.01× Interest Equity .01VU .01× Profits Total .01(VU + D L ) .01× (Profits-Interest)McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved
    7. 17- 7 M&M (Debt Policy Doesn’t Matter) Example - Macbeth Spot Removers - All Equity FinancedDataNumber of shares 1,000Price per share Rs.10Market Value of Shares Rs. 10,000Outcomes A B C DOperating Income Rs.500 1,000 1,500 2,000 ExpectedEarnings per share Rs.0.50 1.00 1.50 2.00 outcomeReturn on shares (%) 5% 10 15 20 McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved
    8. 17- 8 M&M (Debt Policy Doesn’t Matter)Example Data Number of shares 500cont. Price per share Rs.1050% debt Market Value of Shares Rs. 5,000 Market value of debt Rs. 5,000 Outcomes A B C D Operating Income Rs.500 1,000 1,500 2, 000 Interest Rs.500 500 500 500 Equity earnings Rs.0 500 1,000 1,500 Earnings per share Rs.0 1 2 3 Return on shares (%) 0% 10 20 nnMcGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved
    9. 17- 9 M&M (Debt Policy Doesn’t Matter) Example - Macbeth’s - All Equity Financed - Debt replicated by investorsOutcomes A B C DEarnings on two shares Rs.1.00 2.00 3.00 4.00LESS: Interest @ 10% Rs.1.00 1.00 1.00 1.00Net earnings on investment Rs.0 1.00 2.00 3.00Return on $10 investment (%) 0% 10 20 30 McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved
    10. 17- 10 No Magic in Financial Leverage MMS 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.McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved
    11. 17- 11 Proposition I and Macbeth Macbeth continued Cuttent Structure: Proposed Structure: All Equity Equal Debt and EquityExpected earnings per share (Rs.) 1.50 2.00 Price per share (Rs.) 10 10 Expected return per share (%) 15 20McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved
    12. 17- 12 Leverage and Returns expected operating income Expected return on assets = ra = market value of all securities  D   E  rA =  rD ×  +  rE ×   D+E  D+EMcGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved
    13. 17- 13 M&M Proposition II Macbeth continued D rE = rA + ( rA − rD ) V expected operating income rE = rA = market value of all securities 1500 = = .15 10,000McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved
    14. 17- 14 M&M Proposition II D rE = rA + ( rA − rD ) Macbeth continued V expected operating income rE = rA = market value of all securities 1500 = = .15 10,000 5000 rE = .15 + ( .15 − .10) 5000 = .20 or 20%McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved
    15. 17- 15 Leverage and Risk Macbeth continued Leverage increases the risk of Macbeth shares Operating Income Change $1,500 to $500 All equity Earnings per share (Rs.) 1.50 0.50 -$1.00 Return on shares 15% 5% -10% 50 % debt: Earnings per share (Rs.) 2 0 -$2.00 Return on shares 20% 0 -20%McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved
    16. 17- 16 Leverage and Returns Market Value Balance Sheet example Asset Value 100 Debt (D) 40 Equity (E) 60 Asset Value 100 Firm Value (V) 100 rd = 7.5%  D   E  rA =  rD ×  +  rE ×  re = 15%  D+E  D+E  40   60  rA =  .075 ×  +  .15 ×  = 12.75%  100   100 McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved
    17. 17- 17 Leverage and Returns Market Value Balance Sheet example – continued What happens to Re when debt costs rise? Asset Value 100 Debt (D) 40 Equity (E) 60 Asset Value 100 Firm Value (V) 100 rd = 7.5% changes to 7.875% re = ??  40   60  .1275 =  .07875 ×  +  re ×   100   100  re = 16.0%McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved
    18. 17- 18 Leverage and Returns  D  E BA =  BD ×  +  BE ×   V  V D BE = B A + ( B A − BD ) VMcGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved
    19. 17- 19 WACC  WACC is the traditional view of capital structure, risk and return.  D  E WACC = rA =  rD ×  +  rE ×   V  VMcGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved
    20. 17- 20 WACC r rE rE =WACC rD D VMcGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved
    21. 17- 21 M&M Proposition II r rE rA rD D Risk free debt Risky debt EMcGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved
    22. 17- 22 WACC (traditional view) r rE WACC rD D VMcGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved
    23. 17- 23 WACC (M&M view) r rE WACC rD D VMcGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved
    24. 17- 24 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.  D  E WACC =  rD ×  +  rE ×   V  V Old FormulaMcGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved
    25. 17- 25 After Tax WACC Tax Adjusted Formula D  E WACC = rD × (1 − Tc) ×   +  rE ×  V   VMcGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved
    26. 17- 26 After Tax WACC Example - Titan Industries Limited The firm has a marginal tax rate of 33.66%. The cost of equity is 20.0% and the pretax cost of debt is 8.48%. Given the book and market value balance sheets, what is the tax adjusted WACC?McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved
    27. 17- 27 After Tax WACC Example – Titan Industries - continued Debt (D ) Rs 318 crores at rD 8.48% Equity (E ) 2443.8 at rE 20% Preference Capital (P) 40 at rP 12% Firm value (V ) Rs 2802 million MARKET VALUESMcGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved
    28. 17- 28 After Tax WACC Example – Titan Industries - continued Debt ratio = (D/V) = 318 / 2802 = .11 or 11% Equity ratio = (E/V) = 2444 / 2802 = .87 or 87% Preference Capital ratio = (P/V) = 0.02 or 2% D E P After-tax WACC = rD (1 − Tc ) + rE + rP V V VMcGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved
    29. 17- 29 After Tax WACC Example – Titan Industries - continued D E P WACC = rD (1 − Tc ) + rE + rP V V V After-tax WACC = 0.0848 × (1-0.3366) × 0.11 + 0.12 × 0.02 + 0.2 × 0.87 = 0.1825, or 18.25%McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved
    30. 17- 30 Web Resources Click to access web sites Internet connection required www.finance.yahoo.com/ www.valuepro.netMcGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved

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