Does Debt Policy Matter?

• Student Presentations• Capital Structure Considerations• Modigliani and Miller – Propositions 1 and 2• Financial Risk and Expected Returns• Weighted Average Cost of Capital (WACC)• After Tax WACC

Capital Structure• Capital structure is mixture of debt and equity• Firm value is total value of debt plus equity• Types of equity

– Common– Preferred

• Types of debt– Term– Seniority– Covenants

• Hybrids– Convertible bonds

Modigliani and Miller – Proposition 1

• Capital structure does not matter if:– Total cash flows do not change based on capital

structure– Markets are perfect

• No frictions (taxes or bankruptcy costs)• Corporations have no borrowing advantage• Investors have access to any desired investment

• This means that if the capital markets are providing adequate investment choices, then a firm’s value is independent of the debt ratio

Illustration of M&M Prop. 1Two firms with exactly the same operating incomeInvestor owns 1% of each firm’s securitiesFirm U is unlevered (all equity)

Firm L is levered (has issued debt)

Therefore, the value of the two firms must be equalL

LL

L

L

01V.

Profits01.)E01(D.Total

Interest)-Profits(01.01E.Equity

Interest.0101D.Debt

urnDollar RetInvestmentDollar

Profits01.01V.

urnDollar RetInvestmentDollar

U

Another Illustration• Investor owns 1% of levered firm L

• Investor owns 1% of unlevered firm U and borrows an amount equal to 1% of the debt of the levered firm

• Therefore, the value of the two firms must be equal

).01(V

interest)-Profits(01.01E.

urnDollar RetInvestmentDollar

LL

L

D

Interest)-Profits(01.)D01(V.Total

Profits01.01V.Equity

Interest.01-01D.Borrowing

ReturnDollar InvestmentDollar

LU

U

L

Modigliani and Miller's Proposition I states that:

A) The market value of any firm is independent of its capital structure

B) The market value of a firm's debt is independent of its capital structure

C) The market value of a firm's common stock is independent of its capital structure

D) All of the above

E) None of the above

Law of Conservation of Value

• Two streams of cash flow– Stream A has a present value of PV(A)– Stream B has a present value of PV(B)

• Value additivity– The present value of the combined cash flows A+B

is PV(A) + PV(B)

• Conservation of value– Splitting up a cash flow into different parts does

not affect the total value of the parts

Example Macbeth Spot RemoversTable 17.1 – All Equity Financed

201510% 5(%) shareson Return

2.001.501.00$.50shareper Earnings

2,0001,5001,000$500Income Operating

D C B A

Outcomes

10,000 $Shares of ValueMarket

$10shareper Price

1,000shares ofNumber

Data

Table 17.2 – Half Debt/Half Equity

3020100%(%) shares on Return

321$0shareper Earnings

500,11,000500$0earningsEquity

500500500$500Interest

000,21,5001,000$500Income Operating

CBA

Outcomes

5,000 $debt of ueMarket val

5,000 $Shares of ValueMarket

$10shareper Price

500shares ofNumber

Data

D

Table 17.3 – All Equity Firm, Investor Leverage to Borrow Enough to Purchase Another Share

3020100%(%) investment$10 on Return

3.002.001.000 $investment on earningsNet

1.001.001.00$1.0010% @Interest :LESS

4.003.002.00$1.00shares twoon Earnings

DCBA

Outcomes

The law of conservation of value implies that:A) The value of a firm's common stock is

unchanged when debt is added to its capital structure

B) The value of any asset is preserved regardless of the nature of the claims against it

C) The value of a firm's debt is unchanged when common stock is added to its capital structure

D) All of the above E) None of the above

Financial Risk and Expected Returns

securities all of uemarket val

income operating expectedr assetson return Expected A

ED

Er

ED

Drr EDA

E

Drrrr DAAE

M&M Proposition 2

“The expected rate of return on the common stock of a levered firm increases in proportion to the debt-equity ratio (D/E), expresses in market values; the rate of increase depends on the spread between the expected return on a portfolio of all the firm’s securities and the expected return on the debt.”

Illustration of M&M Prop. 2

• Macbeth Spot Removers – All equity

• Half debt (at 10% interest) and half equity

15.000,10

1500securities all of uemarket val

income operating expectedr r AE

20%or 20.5000

500010.15.15.

Er

Table 17.4 – Financial Leverage Increases Risk

20%-020%shareson Return

$2.00-02($) shareper Earnings:debt % 50

10%-5%15%shareson Return

$1.00-0.501.50($) shareper Earningsequity All

Change$500

Income

to$1,500

Operating

Health and Wealth Company is financed entirely by common stock which is priced to offer a 15% expected return. If the company repurchases 25% of the common stock and substitutes an equal value of debt yielding 6%, what is the expected return on the common stock after refinancing? (Ignore taxes.)

A) 12%

B) 15%

C) 18%

D) 21%

E) None of the above

How Change in Capital Structure Affects Beta

V

EB

V

DBB EDA

DAAE BBE

DBB

MM Proposition II states that:

A) The expected return on equity is positively related to leverage

B) The required return on equity is a linear function of the firm's debt to equity ratio

C) The risk to equity increases with leverage

D) All of the above

E) None of the above

The beta of an all equity firm is 1.1. If the firm changes its capital structure to 1/3rd debt and 2/3rds equity using 8% debt financing, what will be the beta of the levered firm? The beta of debt is 0.3. (Assume no taxes.)

A) 1.0

B) 1.1

C) 1.5

D) 1.65

E) None of the above

r

DE

rD

rE

M&M Proposition II

rA

Risk free debt Risky debt

Weighted Average Cost of Capital

V

Er

V

DrrWACC EDA

Practical Problems with M&M• Unsatisfied clientele

– Investors want, and will pay a premium for, securities that offer the particular financial instrument they want (risk, timing, etc.)

– Should be a temporary phenomenon• Government regulation

– Restrictions on interest rates or available investments• The impact of capital structure on cash flows

– Taxation issues– Interest paid on corporate debt is a tax deduction

After-Tax WACC

rate tax corporate marginal Tc where

)1(

V

Er

V

DTcrWACC ED

Next Few Classes• Thursday, April 5

– Case 2 – A-Rod– Case is available in 340 Wohlers– Be prepared to discuss the case in class

• Tuesday, April 10– How much should a firm borrow? – Chapter 18

• Thursday, April 12– Financing and valuation – Chapter 19