Good PPT on Capital Structures - Bma9e18

Chapter 18 PrinciplesPrinciples

ofof

CorporateCorporate

FinanceFinance

Ninth Edition

Does Debt Policy Matter?

Slides by

Matthew Will

Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved

McGraw Hill/Irwin


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McGraw Hill/Irwin

Topics Covered

Leverage in a Competitive Tax Free Environment

Financial Risk and Expected ReturnsThe Weighted Average Cost of CapitalA Final Word on After Tax WACC


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McGraw Hill/Irwin

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.


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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


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McGraw Hill/Irwin


Profits01.01V.

urnDollar RetInvestmentDollar

U

L

LL

L

L

01V.

Profits01.)E01(D.Total

Interest)-Profits(01.01E.Equity

Interest.0101D.Debt



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McGraw Hill/Irwin


).01(V

interest)-Profits(01.01E.


LL

L

D

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

Profits01.01V.Equity

Interest.01-01D.Borrowing


LU

U

L


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McGraw Hill/Irwin

Example - Macbeth Spot Removers - All Equity Financed

201510% 5(%) shares on Return

2.001.501.00$.50shareper Earnings

2,0001,5001,000$500Income Operating

D C BA

Outcomes

10,000 $Shares of ValueMarket

$10shareper Price

1,000shares ofNumber

Data


Expected outcome


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McGraw Hill/Irwin

Example

cont.

50% debt


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


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McGraw Hill/Irwin

Example - Macbeth’s - All Equity Financed

- Debt replicated by investors

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



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Borrowing and EPS at Macbeth


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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.

No Magic in Financial Leverage


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McGraw Hill/Irwin

Proposition I and Macbeth

2015(%) shareper return Expected

1010($) shareper Price

2.001.50($) shareper earnings Expected Equityand Debt Equal

:Structure Proposed

EquityAll

:StructureCuttent

Macbeth continued


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McGraw Hill/Irwin

Leverage and Returns

securities all of uemarket val

income operating expectedr assets on return Expected a

ED

Er

ED

Drr EDA


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McGraw Hill/Irwin

M&M Proposition II

15.000,10

1500securities all of uemarket val

income operating expectedr r AE

E

Drrrr DAAE

Macbeth continued


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M&M Proposition II

E

Drrrr DAAE

15.000,10

1500securities all of uemarket val

income operating expectedr r AE

20%or 20.5000

500010.15.15.

Er

Macbeth continued


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McGraw Hill/Irwin

Leverage and Risk

20%-020%shares on Return

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

10%-5%15%shares on Return

$1.00-0.501.50($) shareper Earningsequity All

Change$500

Income

to$1,500

Operating

20%-020%shares on Return

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

10%-5%15%shares on Return

$1.00-0.501.50($) shareper Earningsequity All

Change$500

Income

to$1,500

Operating

Macbeth continued

Leverage increases the risk of Macbeth shares


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McGraw Hill/Irwin


%75.12100

6015.

100

40075.

A

EDA

r

ED

Er

ED

Drr

Asset Value 100 Debt (D) 40

Equity (E) 60

Asset Value 100 Firm Value (V) 100

rd = 7.5%

re = 15%

Market Value Balance Sheet example


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McGraw Hill/Irwin


%0.16

100

60

100

4007875.1275.

e

e

r

r

Asset Value 100 Debt (D) 40

Equity (E) 60

Asset Value 100 Firm Value (V) 100

rd = 7.5% changes to 7.875%

re = ??

Market Value Balance Sheet example – continued

What happens to Re when debt costs rise?


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V

EB

V

DBB EDA

V

EB

V

DBB EDA

DAAE BBV

DBB DAAE BB

V

DBB


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WACC

V

Er

V

DrrWACC EDA

V

Er

V

DrrWACC EDA

WACC is the traditional view of capital structure, risk and return.


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r

DV

rD

rE

rE =WACC

WACC


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r

DE

rD

rE

M&M Proposition II

rA

Risk free debt Risky debt


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r

DV

rD

rE

WACC

WACC (traditional view)


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McGraw Hill/Irwin

r

DV

rD

rE

WACC

WACC (M&M view)


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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.

V

Er

V

DrWACC ED

V

Er

V

DrWACC ED

Old Formula


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After Tax WACC

V

Er

V

DTcrWACC ED )1(

Tax Adjusted Formula


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McGraw Hill/Irwin

After Tax WACC

Example - Union Pacific

The firm has a marginal tax rate of 35%. The cost of equity is 12.0% and the pretax cost of debt is 6.0%. Given the book and market value balance sheets, what is the tax adjusted WACC?


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McGraw Hill/Irwin

After Tax WACC

Example - Union Pacific - continued

Balance Sheet (Market Value, billions)Assets 32.9 6.7 Debt

26.2 EquityTotal assets 32.9 32.9 Total liabilities


26.2 EquityTotal assets 32.9 32.9 Total liabilities

MARKET VALUES


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McGraw Hill/Irwin

After Tax WACC


V

Er

V

DTcrWACC ED )1(

Debt ratio = (D/V) = 6.7/32.9= .20 or 20%

Equity ratio = (E/V) = 26.2/32.9 = .80 or 80%


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McGraw Hill/Irwin

After Tax WACC


V

Er

V

DTcrWACC ED )1(

%4.10

104.

80.12.20.)35.1(06.

WACC


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McGraw Hill/Irwin

After Tax WACC

Another Example - Kate’s Cafe

Kate’s Café has a marginal tax rate of 35%. The cost of equity is 10.0% and the pretax cost of debt is 5.5%. Given the book and market value balance sheets, what is the tax adjusted WACC?


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McGraw Hill/Irwin

After Tax WACC

Another Example - Kate’s Cafe- continued


15 EquityTotal assets 22.6 22.6 Total liabilities


15 EquityTotal assets 22.6 22.6 Total liabilities

MARKET VALUES


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McGraw Hill/Irwin

After Tax WACC


V

Er

V

DTcrWACC ED )1(

Debt ratio = (D/V) = 7.6/22.6= .34 or 34%

Equity ratio = (E/V) = 15/22.6 = .66 or 66%


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McGraw Hill/Irwin

After Tax WACC


V

Er

V

DTcrWACC ED )1(

%8.7

078.

66.10.34.)35.1(055.

WACC


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McGraw Hill/Irwin

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Good PPT on Capital Structures - Bma9e18