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# WACC and Debt Policy - PowerPoint PPT Presentation

WACC and Debt Policy Optimal Capital Structure? M&M (Debt Policy Doesn’t Matter) Modigliani & Miller (Proposition I) When there are no taxes and capital markets are perfect, the market value of a company does not depend on its capital structure.

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WACC and Debt Policy

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## WACC and Debt Policy

Optimal Capital Structure?

### M&M (Debt Policy Doesn’t Matter)

• Modigliani & Miller (Proposition I)

• When there are no taxes and capital markets are perfect, the market value of a company does not depend on its capital structure.

The Value of the firm does not change with debt:

VL = VU

### Return on Assets (wacc)No Taxes

Note: rA = WACC (with no taxes)

### M&M Proposition II

The cost of equity capital increases with financial

leverage – due to the increase in Risk!

V = D + E

These should be Market values!

r

rE

rA = WACC

rD

D

E

Risk free debt

Risky debt

Impact on Beta

### Leverage and Returns

Impact on Beta

If the Beta of Debt is assumed to be Zero

BD = 0

The Beta of the Levered Firm is Equal to the

Beta of the Unlevered Firm (or Asset Beta) times

One plus the Debt-to-Equity Ratio

Note: Equity betas are levered betas and asset betas are

unlevered betas (L=E and U=A).

### WACC (no taxes)

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

### Capital Structurewith taxes

D x rD x Tc

rD

= D x Tc

PV of Tax Shield =

(assume perpetuity)

Firm Value =

Value of All Equity Firm + PV Tax Shield

VL = VU + TC x D

MM Proposition I with Corporate Taxes

### MM Prop. I with Taxes

Value of levered firm

PV of interest

tax shields

Market Value of The Firm

Value of

unlevered

firm

Optimal amount

of debt

Debt

### MM with Corporate Taxes

MM Proposition II with Corporate Taxes

r0 = the return on the all equity financed firm (the unlevered

firm or the return on the assets of the firm)

### Debt and Taxes

Impact on Beta

If the Beta of Debt is assumed to be Zero

BD = 0

Remember, βL is the equity beta for a firm with leverage, and

βU is the beta for the firm with NO debt

r

rE

r0

WACC

rD

D

V

### Financial Distress

Costs of Financial Distress - Costs arising from bankruptcy or distorted business decisions before bankruptcy.

Market Value =Value if all Equity Financed

+ PV Tax Shield

- PV Costs of Financial Distress

### Financial Distress

Maximum value of firm

Costs of

financial distress

PV of interest

tax shields

Market Value of The Firm

Value of levered firm

Value of

unlevered

firm

Optimal amount

of debt

Debt

### WACC with Taxes

Important: The WACC Formula

Weighted Average Cost of Capital (with costs of financial distress)

r

rE

WACC

rD

D

V

Optimal amount

of debt

### Costs of Debt

• Financial Distress Costs

• Personal Tax Disadvantage of Debt

• Agency Costs

• Information Costs (or Benefits) of Debt

• The Pecking Order Theory