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Chapter 17

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.

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Chapter 17

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  1. Chapter 17 Principles of Corporate Finance, 8/e (Special Indian Edition) Does Debt Policy Matter?

  2. 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

  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)

  6. M&M (Debt Policy Doesn’t Matter)

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

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

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

  10. 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.

  11. Proposition I and Macbeth Macbeth continued

  12. Leverage and Returns

  13. M&M Proposition II Macbeth continued

  14. M&M Proposition II Macbeth continued

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

  16. 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%

  17. 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 = ??

  18. Leverage and Returns

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

  20. WACC r rE rE =WACC rD D V

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

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

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

  24. 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

  25. After Tax WACC Tax Adjusted Formula

  26. 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?

  27. After Tax WACC Example – Titan Industries - continued MARKET VALUES

  28. 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 =

  29. 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%

  30. Web Resources Web Links Click to access web sites Internet connection required www.finance.yahoo.com/ www.valuepro.net

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