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Slides by Matthew Will

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  1. Principles of Corporate Finance Brealey and Myers Sixth Edition • Does Debt Policy Matter? Slides by Matthew Will Chapter 17 Irwin/McGraw Hill • The McGraw-Hill Companies, Inc., 2000

  2. Topics Covered • Leverage in a Tax Free Environment • How Leverage Effects Returns • The Traditional Position

  3. 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.

  4. 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

  5. M&M (Debt Policy Doesn’t Matter) Example - Macbeth Spot Removers - All Equity Financed Expected outcome


  6. M&M (Debt Policy Doesn’t Matter) Example cont. 50% debt

  7. M&M (Debt Policy Doesn’t Matter) Example - Macbeth’s - All Equity Financed - Debt replicated by investors

  8. 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.

  9. Proposition I and Macbeth Macbeth continued

  10. Leverage and Returns

  11. M&M Proposition II Macbeth continued

  12. M&M Proposition II Macbeth continued

  13. M&M Proposition II r rE rA rD D E Risk free debt Risky debt

  14. Leverage and Risk Macbeth continued Leverage increases the risk of Macbeth shares

  15. Leverage and Returns

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

  17. WACC Expected Return .20=rE Equity .15=rA All assets .10=rD Debt Risk BD BA BE

  18. WACC Example - A firm has $2 mil of debt and 100,000 of outstanding shares at $30 each. If they can borrow at 8% and the stockholders require 15% return what is the firm’s WACC? D = $2 million E = 100,000 shares X $30 per share = $3 million V = D + E = 2 + 3 = $5 million

  19. WACC Example - A firm has $2 mil of debt and 100,000 of outstanding shares at $30 each. If they can borrow at 8% and the stockholders require 15% return what is the firm’s WACC? D = $2 million E = 100,000 shares X $30 per share = $3 million V = D + E = 2 + 3 = $5 million

  20. WACC r rE rE =WACC rD D V

  21. WACC (traditional view) r rE WACC rD D V

  22. WACC (M&M view) r rE WACC rD D V