A Teaching Application for Assessing the Impact of Debt

1. A Teaching Application forAssessing the Impact of Debt Professor Robert M. Hull and Daniel McNulty Beatrice Presentation: March 2007

2. An Important Issue Choosing an optimal amount of debt is a central topic in financial management courses and one of the key decisions faced by financial managers. Consequently, instructors need to properly teach the relationship between a firm's debt level and its value

3. The Problem • Researchers argue that a tool for teaching capital structure decision-making is missing due to lack of an adequate equation.

4. The Problem Continues • Graham and Harvey (2001) find that financial executives are much less likely to follow prescribed academic capital structure theories compared to other finance theories.

5. Review of Major Capital Structure Models • Modigliani and Miller made the original model in 1963

6. The Extended Model • Miller extended the model in 1977

7. A New EquationHull (2007)

8. Miller’s beliefs about the model • Miller believed that alpha was equal to one, thus eliminating any gain resulting from leverage. His beliefs are not the consensus view of capital structure theorists.

10. What does this all mean? • The 1963 Modigliani & Miller model, and the 1977 Miller model produce an optimal debt level at 100% to maximize the value of the company. Is this realistic?

11. The real world is not linear Both the MM and the Miller models are of a linear nature. Although these models are the founding backbone of corporate financial theory, they find little use in terms of making practical real world decisions about corporate structure.

12. The Hull Equation • The Hull equation models the gain to leverage with a non-linear, concave shaped model. It does this by taking into account key factors that are left out of previous models. These include the cost of leveraged equity and the cost of debt, which are variables central to capital structure decisions.

13. By having students perform the exercises in this paper, it creates a greater appreciation for the models involved. • Having students take a hands-on approach with this application embeds a deeper understanding of the models themselves, how they work, and how changes effect them. This in turn should allow them to make more practical use of capital structure theory.

14. My Classroom Experience • I gained a much deeper appreciation for the Hull model • Others seemed to really see how the Hull model built upon previous work to create a more accurate look at capital structure mix • The Hull model altered the previous perception towards capital structure models.