Chap017

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  • Chap017

    1. 1. Principles of Chapter 17 Corporate Finance Tenth Edition Does Debt Policy Matter? Slides by Matthew WillMcGraw-Hill/Irwin Copyright © 2011 by the McGraw-Hill Companies, Inc. All rights reserved.
    2. 2. 17-2 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
    3. 3. 17-3M&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.
    4. 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 incentives
    5. 5. 17-5M&M (Debt Policy Doesn’t Matter) Dollar Investment Dollar Return .01VU .01 × Profits Dollar Investment Dollar Return Debt .01D L .01× Interest Equity .01E L .01× ( Profits - Interest) Total .01(D L + E L ) .01× Profits = .01VL
    6. 6. 17-6M&M (Debt Policy Doesn’t Matter) Dollar Investment Dollar Return .01E L .01 × ( Profits - interest) = .01(VL − DL ) Dollar Investment Dollar Return Borrowing − .01D L - .01 × Interest Equity .01VU .01 × Profits Total .01(VU + D L ) .01 × ( Profits - Interest)
    7. 7. 17-7 M&M (Debt Policy Doesn’t Matter) Example - Macbeth Spot Removers - All Equity FinancedDataNumber of shares 1,000Price per share $10Market Value of Shares $ 10,000Outcomes A B C DOperating Income $500 1,000 1,500 2,000 ExpectedEarnings per share $.50 1.00 1.50 2.00 outcomeReturn on shares (%) 5% 10 15 20
    8. 8. 17-8 M&M (Debt Policy Doesn’t Matter)Example Data Number of shares 500cont. Price per share $1050% debt Market Value of Shares $ 5,000 Market value of debt $ 5,000 Outcomes A B C D Operating Income $500 1,000 1,500 2,000 Interest $500 500 500 500 Equity earnings $0 500 1,000 1,500 Earnings per share $0 1 2 3 Return on shares (%) 0% 10 20 30
    9. 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 $1.00 2.00 3.00 4.00LESS : Interest @ 10% $1.00 1.00 1.00 1.00Net earnings on investment $0 1.00 2.00 3.00Return on $10 investment (%) 0% 10 20 30
    10. 10. 17-10Borrowing and EPS at Macbeth
    11. 11. 17-11No Magic in Financial LeverageMMS PROPOSITION I If capital markets are doing their job, firms cannot increase value by tinkering with capital structure. V is independent of the debt ratio.AN EVERYDAY ANALOGY It should cost no more to assemble a chicken than to buy one whole.
    12. 12. 17-12 Proposition I and Macbeth Macbeth continued Cuttent Structure : Proposed Structure : All Equity Equal Debt and EquityExpected earnings per share ($) 1.50 2.00 Price per share ($) 10 10Expected return per share (%) 15 20
    13. 13. 17-13 Leverage and Returns expected operating incomeExpected return on assets = ra = market value of all securities  D   E  rA =  × rD  +  × rE  D+E  D+E 
    14. 14. 17-14 M&M Proposition II Macbeth continued DrE = rA + ( rA − rD ) E expected operating income rE = rA = market value of all securities 1500 = = .15 10,000
    15. 15. 17-15 M&M Proposition II DrE = rA + ( rA − rD ) Macbeth continued E expected operating income rE = rA = market value of all securities 1500 = = .15 10,000 5000 rE = .15 + ( .15 − .10) 5000 = .20 or 20%
    16. 16. 17-16 Leverage and Risk Macbeth continuedLeverage increases the risk of Macbeth shares Operating Income Change $1,500 to $500All equity Earnings per share ($) 1.50 0.50 - $1.00 Return on shares 15% 5% - 10%50 % debt : Earnings per share ($) 2 0 - $2.00 Return on shares 20% 0 - 20%
    17. 17. 17-17 Leverage and Returns Market Value Balance Sheet exampleAsset Value 100 Debt (D) 40 Equity (E) 60Asset Value 100 Firm Value (V) 100rd = 7.5%  D   E  rA =  rD ×  +  rE ×   D+E  D+Ere = 15%  40   60  rA =  .075 ×  +  .15 ×  = 12.75%  100   100 
    18. 18. 17-18 Leverage and Returns Market Value Balance Sheet example – continuedWhat 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%
    19. 19. 17-19Leverage and Returns  D  EBA =  BD ×  +  BE ×   V  V D BE = B A + ( B A − BD ) V
    20. 20. 17-20 WACC WACC is the traditional view of capital structure, risk and return.  D  E WACC = rA =  rD ×  +  rE ×   V  V
    21. 21. 17-21 WACC r rE rA = WACCrD D V
    22. 22. 17-22M&M Proposition II
    23. 23. 17-23WACC (traditional view)
    24. 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 Formula
    25. 25. 17-25 After Tax WACC Tax Adjusted Formula D  EWACC = rD × (1 − Tc) ×   +  rE ×  V   V
    26. 26. 17-26 After Tax WACCExample - Union PacificThe firm has a marginal tax rate of35%. The cost of equity is 9.9% andthe pretax cost of debt is 7.8%. Giventhe book and market value balancesheets, what is the tax adjusted WACC?
    27. 27. 17-27 After Tax WACCExample - Union Pacific - continued Balance Sheet (Market Value, billions) Assets 200 63 Debt 137 Equity Total assets 200 200 Total liabilities MARKET VALUES
    28. 28. 17-28 After Tax WACCExample - Union Pacific - continuedDebt ratio = (D/V) = 63/200= .315 or 31.5%Equity ratio = (E/V) = 137/200 = .685 or 68.5% D  EWACC = rD × (1 − Tc) ×   +  rE ×  V   V
    29. 29. 17-29 After Tax WACC Example - Union Pacific - continued D  E WACC = rD × (1 − Tc) ×   +  rE ×  V   VWACC = (1 − .35) × .078 × ( .315) + .099( .685) = .084 = 8.4%
    30. 30. 17-30Union Pacific WACC
    31. 31. 17-31 After Tax WACCAnother Example - Kate’s CafeKate’s Café has a marginal tax rate of35%. The cost of equity is 10.0% andthe pretax cost of debt is 5.5%. Giventhe book and market value balancesheets, what is the tax adjusted WACC?
    32. 32. 17-32 After Tax WACC Another Example - Kate’s Cafe- continuedBalance Sheet (Market Value, billions)Assets 22.6 7.6 Debt 15 EquityTotal assets 22.6 22.6 Total liabilities MARKET VALUES
    33. 33. 17-33 After Tax WACC Another Example - Kate’s Cafe- continuedDebt ratio = (D/V) = 7.6/22.6= .34 or 34%Equity ratio = (E/V) = 15/22.6 = .66 or 66% D  EWACC = rD × (1 − Tc) ×   +  rE ×  V   V
    34. 34. 17-34 After Tax WACCAnother Example - Kate’s Cafe- continued D  EWACC = rD × (1 − Tc) ×   +  rE ×  V   V WACC = .055 × (1 − .35)( .34 ) + .10( .66) = .078 = 7.8%
    35. 35. 17-35 Web ResourcesClick to access web sitesInternet connection required http://finance.yahoo.com www.valuepro.net

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