68 Views

Download Presentation
## Chapter 17

- - - - - - - - - - - - - - - - - - - - - - - - - - - E N D - - - - - - - - - - - - - - - - - - - - - - - - - - -

**Chapter 17**Principles of Corporate Finance, 8/e (Special Indian Edition) Does Debt Policy Matter?**Topics Covered**• Leverage in a Competitive Tax Free Environment • Financial Risk and Expected Returns • The Weighted Average Cost of Capital • A Final Word on After Tax WACC**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.**M&M (Debt Policy Doesn’t Matter)**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**M&M (Debt Policy Doesn’t Matter)**Example - Macbeth Spot Removers - All Equity Financed Expected outcome**M&M (Debt Policy Doesn’t Matter)**Example cont. 50% debt**M&M (Debt Policy Doesn’t Matter)**Example - Macbeth’s - All Equity Financed - Debt replicated by investors**No Magic in Financial Leverage**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.**Proposition I and Macbeth**Macbeth continued**M&M Proposition II**Macbeth continued**M&M Proposition II**Macbeth continued**Leverage and Risk**Macbeth continued Leverage increases the risk of Macbeth shares**Leverage and Returns**Market Value Balance Sheet example Asset Value 100 Debt (D) 40 Equity (E) 60 Asset Value 100 Firm Value (V) 100 rd = 7.5% re = 15%**Leverage and Returns**Market Value Balance Sheet example – continued What happens to Re when debt costs rise? Asset Value 100 Debt (D) 40 Equity (E) 60 Asset Value 100 Firm Value (V) 100 rd = 7.5% changes to 7.875% re = ??**WACC**• WACC is the traditional view of capital structure, risk and return.**WACC**r rE rE =WACC rD D V**M&M Proposition II**r rE rA rD D E Risk free debt Risky debt**WACC (traditional view)**r rE WACC rD D V**WACC (M&M view)**r rE WACC rD D V**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. OldFormula**After Tax WACC**Tax Adjusted Formula**After Tax WACC**Example - Titan Industries Limited The firm has a marginal tax rate of 33.66%. The cost of equity is 20.0% and the pretax cost of debt is 8.48%. Given the book and market value balance sheets, what is the tax adjusted WACC?**After Tax WACC**Example – Titan Industries - continued MARKET VALUES**After Tax WACC**Example – Titan Industries - continued Debt ratio = (D/V) = 318 / 2802 = .11 or 11% Equity ratio = (E/V) = 2444 / 2802 = .87 or 87% Preference Capital ratio = (P/V) = 0.02 or 2% After-tax WACC =**After Tax WACC**Example – Titan Industries - continued WACC = After-tax WACC = 0.0848 (1-0.3366) 0.11 + 0.12 0.02 + 0.2 0.87 = 0.1825, or 18.25%**Web Resources**Web Links Click to access web sites Internet connection required www.finance.yahoo.com/ www.valuepro.net