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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 1 06/04/2015 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 2 06/04/2015 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 3 06/04/2015 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 4 06/04/2015 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 5 06/04/2015 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 6