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06/04/2015
Chapter
THE QUESTIONS
17
• Is it possible to increase the value of the
firm by some mix of debt and equity?
• Modigliani and Miller (1958) said NO, it
DOES DEBT POLICY MATTER?
does not matter
• What are the pros and cons of equity and
Brealey, Myers, and Allen
Principles of Corporate Finance
11th Global Edition
McGraw-Hill Education
debt? (From a pure financing perspective)
• Equity acts like a buffer for drops in income
• Debt is good when income is high (no need to share)
but bad when income is low (you still have to pay
interest)
Copyright © 2015 by Bo Sjö and The McGraw-Hill Companies, Inc. All rights reserved.
LEARNING
17-2
SOME VERY WRONG STATEMENTS
• There some theories. Explain how they are
• ”Firms should avoid debt totally”
related and what are the implications?
• ”Firms should be financed with debt only”
• Everything starts with M&M
• ”Since a business loan costs 4% in intrest
• The textbook does not present the recent
and the required return on equity is 8% you
should borrow because it is cheaper to
borrow.”
theories well – Asymmetric information
problem (relates also to principal-agent
theories). Next lecture power points.
17-3
LOOK AT THE BALANCE SHEET
17-4
17-1 ENTERS MODIGLIANI & MILLER
• Modigliani & Miller set up a free-
• Total assets are discounted value of the
competition economy where
free cash flows, can this value increase if
we change the Debt/equity structure?
1. There are no transaction costs
• Can WACC change?
2. There are no taxes and where
• Can the Free Cash Flows change?
bankruptcy proceedings are costless
(creditors can just take-over)
• The basic answer is no – but why?
3. Where every-one has the same
• The extended answer is that maybee there
information (mangers-shareholdersbond holders)
are some links after all. M&M:s provide the
answers.
17-5
17-6
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THE COST OF EQUITY IS NOT GIVEN
DEBT IS GOOD IN GOOD TIMES…
• If a firm financing its expansion with equity only
• High earnings:
=> higher earnings => higher earnings pre share
(earnings=dividends, earnings will fluctuate but
the firm can pay out as much as it wants from all
of its earnings)
• With debt: as earnings go up you don’t
have to share the profit. Share holders are
better of. Debt holders get interest nothing
more.
• If the firm borrows money instead the effect is
also higher earnings, but since earnings will
fluctuate it has consequences for the amount of
dividends that can be paid out from the earnings.
• Low earnings:
• With debt, as earnings falls low, you have
to pay interest first, => less money for
dividends
• You must always pay out interest independent of
earnings
17-7
FIGURE 17.1 BORROWING INCREASES
MACBETH’S EPS => EQUITY GETS RISKIER
17-8
MODIGLIANI AND MILLER
• With only equity financing: business risk
• With equity + debt financing: business risk
+ financial risk
• M&M show that with borrowing the
business risk increases with debt so that
the required risk-adjusted return on equity
increses 1:1 with higher Debt/Equity
17-10
17-9
M&M PROPOSITION I: CONSTANT WACC
M&M PROPOSITION II
• WACC remains constant as the shares of
•
debt and equity changes.
As the share of debt increases so does the required
return on equity. Shown by rewriting the WACC formula:
• The expected leveraged earnings
increases
• => Earnings per share increases
• => The value of the shares cannot
increase because the discounted value of
earnings per share will remain the same.
• Thus NO increase in the value of the firm.
17-11
17-12
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ASSET (PORTFOLIO) BETA
EQUITY BETA FOR ANY D/E RATIO
•
•
17-13
UNLEVERING EQUITY BETA
17-14
A USEFUL FORMULA
•
•
17-15
THE M&M PRINCIPLE
17-16
ALL THE DIFFERENT BETA
• There no optimal debt/equity ratio
• Asset Beta
• D/E doesn’t matter, Modigliani has always
• Equity Beta
defened this conclusion
• Levered Beta
• More far reaching:
• Unlevered Beta
• A firm should never do for the share
• (Adjusted Beta)
holders what they can do for themselves
• Don’t diversify the operations of the firm, the
shareholders can diversify on their own.
17-17
17-18
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BE AWARE OF BETA
THE PURE PLAY METHOD TO THE COST OF CAPITAL
• The (Equity) Beta you estimate from market data
• Instead of using the beta of one firm (say
is affected by the firm’s D/E ratio.
• Use M&M prop II to calculate the all-equity Beta.(=
Asset Beta=unlevered beta)
“your firm”)
• Estimate the unlevered Beta for similar
firms and calculate the average sector Beta
• The mean of all-equity (unlevered) Betas over an
• Then do (Ch 19)
industry sector gives the ”sector Beta”.
With an all-equity (unlevred) Beta, this all-equity
Beta can be relevered to give the Beta for any
desiered D/E ratio for a given firm.
• APV
• Or, relever this Beta get the relevant cost of
equity capital for the specific firm/project you
work with. (Given a D/E ratio target)
17-19
17-20
17-2 FINANCIAL RISK AND EXPECTED
RETURNS
RELAX THE ASSUMPTIONS OF M&M
Proposition II Given 50/50 - D/E
• Is there an optimal D/E ratio after all
• In theory?
• In practice, what do we know?
• The rest of the slides are text books examples
of calculations that I don’t present in class
17-21
CAPITAL STRUCTURE & CORPORATE TAXES
17-22
CAPITAL STRUCTURE & CORPORATE TAXES
The tax deductibility of interest increases the total distributed
income to both bondholders and shareholders.
17-23
17-24
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CAPITAL STRUCTURE & CORPORATE TAXES
Capital Structure & Corporate Taxes
Example - You own all the equity of Space Babies Diaper Co. The
company has no debt. The company’s annual cash flow is $900,000
before interest and taxes. The corporate tax rate is 35% You have
the option to exchange 1/2 of your equity position for 5% bonds with
a face value of $2,000,000.
Should you do this and why?
Example - You own all the equity of Space
Babies Diaper Co. The company has no debt.
The company’s annual cash flow is $900,000
before interest and taxes. The corporate tax
rate is 35% You have the option to exchange
1/2 of your equity position for 5% bonds with a
face value of $2,000,000.
Total Cash Flow
All Equity = 585
*1/2 Debt = 620
Should you do this and why?
(520 + 100)
17-25
CAPITAL STRUCTURE & CORPORATE TAXES
PV of Tax Shield
=
D x rD x Tc
(assume perpetuity)
CAPITAL STRUCTURE & CORPORATE TAXES
Firm Value =
= D x Tc
Value of All Equity Firm + PV Tax Shield
rD
Example:
Example
Tax benefit = 2,000,000 x (.05) x (.35) = $35,000
All Equity Value = 585 / .05 = 11,700,000
PV Tax Shield =
PV of $35,000 in perpetuity = 35,000 / .05 = $700,000
700,000
Firm Value with 1/2 Debt = $12,400,000
PV Tax Shield = $2,000,000 x .35 = $700,000
17-27
17-28
17-4 FINAL WORD ON AFTER-TAX WEIGHTEDAVERAGE COST OF CAPITAL
17-4 FINAL WORD ON AFTER-TAX WEIGHTEDAVERAGE COST OF CAPITAL
• Union Pacific
• After-Tax WACC
• Firm has marginal tax rate of 35%
• Tax benefit from interest-expense deductibility
must include cost of funds
• Cost of equity 9.9%
• Tax benefit reduces effective cost of debt by
• Pretax cost of debt 4.7%
factor of marginal tax rate
• Given book-and-market value balance sheet
what is tax-adjusted WACC?
17-29
17-30
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17-4 FINAL WORD ON AFTER-TAX WEIGHTEDAVERAGE COST OF CAPITAL
17-4 FINAL WORD ON AFTER-TAX WEIGHTEDAVERAGE COST CAPITAL
• Union Pacific
• After-Tax WACC
• WACC = (1 – .35) x 4.7 x .160 + 9.9 x .840 =
• Kate’s Café has marginal tax rate of 35%
8.8%
• Cost of equity 10.0% and pretax cost of debt
5.5%
• Given book- and market-value balance sheets,
what is tax-adjusted WACC?
17-31
17-32
17-4 FINAL WORD ON AFTER-TAX WEIGHTEDAVERAGE COST CAPITAL
17-4 FINAL WORD ON AFTER-TAX WEIGHTEDAVERAGE COST CAPITAL
• After-Tax WACC
After-Tax WACC
• Debt ratio = (D/V) = 7.6/22.6 = .34 or
34%
• Equity ratio = (E/V) = 15/22.6 = .66 or
66%
17-33
17-34
17-4 FINAL WORD ON AFTER-TAX WEIGHTEDAVERAGE COST CAPITAL
After-Tax WACC
17-35
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