7.0 does debt policy matter(1)
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8/12/2019 7.0 Does Debt Policy Matter(1)
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Chapter17
Does Debt PolicyMatter?
Slides by
Matthew Will
McGraw-Hill/Irwin Copyright 2011 by the McGraw-Hill Companies, Inc. ll rights reser!e".
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Topics Covered Financial 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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M&M !e"t #olic$ !oesn%t Matter Modigliani & Miller
When there are no taxes and capital marketsfunction 'ell( it makes no difference 'hetherthe firm "orro's or individual shareholders"orro') Therefore( the market value of acompan$ does not depend on its capital
structure)
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M&M !e"t #olic$ !oesn%t MatterAssumptions *$ issuing + securit$ rather than ,( compan$
diminishes investor choice) This does not reducevalue if-
.nvestors do not need choice( /R There are sufficient alternative securities
Capital structure does not affect cash flo's e)g))) 0o taxes 0o "ankruptc$ costs 0o effect on management incentives
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M&M !e"t #olic$ !oesn%t Matter
Profits01.01V.urnDollar RetInvestmentDollar
U
L
LL
L
L
01V.Profits01.)E01(D.Total
Interest)-Profits(01.01E.EquityInterest.0101D.De t
ReturnDollarInvestmentDollar
= +
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M&M !e"t #olic$ !oesn%t Matter
).01(Vinterest)-Profits(01.01E.
urnDollar RetInvestmentDollar
LL
L
D=
Interest)-Profits(01.)D01(V.Total
Profits01.01V.EquityInterest.01-01D.!orro"in#
urnDollar RetInvestmentDollar
LU
U
L
+
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Example 1 Mac"eth 2pot Removers 1 All E3uit$Financed
M M !Debt Policy Doesn"t Matter#
E$%e&te'out&ome
0110*(*)s+aresonReturn.001. 01.00,. 0s+are %erEarnin#s
0001 001 000, 00In&ome%eratin# D/ !
ut&omes
10 000,+aresof Value2ar3et
,10s+are %erPri&e1 000s+aresof 4um er
Data
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Example cont)456 de"t
M M !Debt Policy Doesn"t Matter#
30 20100#$#%shareson &et'rn
51,0s+are %erEarnin#s0011 00000,0earnin#sEquity
000000, 00Interest 0001 001 000, 00In&ome%eratin#
/!
ut&omes
000,'e tof ue2ar3et val000,+aresof Value2ar3et
,10s+are %erPri&e00s+aresof 4um er
Data
D
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Example 1 Mac"eth%s 1 All E3uit$ Financed1 !e"t replicated "$ investors
M M !Debt Policy Doesn"t Matter#
(020100#$#%in!estment )10on &et'rn
5.00.001.000,investmentonearnin#s 4et1.001.001.00,1.0010*6Interest7LE
8.005.00.00,1.00s+arest"oonEarnin#sD/!
ut&omes
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$orrowin% and EPS at Macbeth
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MM72 #R/#/2.T./0 .
.f capital markets are doing their 8o"( firms cannot increase value "$ tinkering
'ith capital structure) 9 is independent of the de"t ratio)
A0 E9ER:!A: A0AL/;:
.t should cost no more to assem"le a chicken than to "u$ one 'hole)
0o Magic in Financial Leverage
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#roposition . and Mac"eth
Macbeth contin'e"
01(*)s+are %erreturnE$%e&te'1010(,)s+are %erPri&e.001. 0(,)s+are %erearnin#sE$%e&te'
Equityan'De tEqual7tru&turePro%ose'
Equityll7tru&ture/uttent
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Leverage and Returns
se&uritiesallof uemar3et valin&omeo%eratin#e$%e&te'
r assetsonreturnE$%e&te' a ==
+
+
+
= E D A r E D
E r
E D
Dr
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M&M #roposition .. Macbeth contin'e"
1.00010
1 00se&uritiesallof uemar3et val
in&omeo%eratin#e$%e&te'r r E
==
==
( ) E
Dr r r r
D A A E +=
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M&M #roposition .. Macbeth contin'e" ( ) E
Dr r r r D A A E +=
1.00010
1 00se&uritiesallof uemar3et valin&omeo%eratin#e$%e&te'
r r E
==
==
( )0*or0.
00000010.1.1.
=+= E r
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Leverage and Risk
Macbeth contin'e" Levera#e in&reases t+e ris3 of 2a& et+ s+ares
0*-00*s+aresonReturn, .00-0(,)s+are %erEarnin#s7'e t*010*-*1 *s+aresonReturn,1.00-0. 01. 0(,)s+are %erEarnin#sequityll
/+an#e, 00In&ome
to,1 00%eratin#
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Leverage and Returns
sset Value 100 De t (D) 80
Equity (E) 90
sset Value 100 :irm Value (V) 100
r' ;
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Leverage and Returns
sset Value 100 De t (D) 80
Equity (E) 90
sset Value 100 :irm Value (V) 100
r' ;
2ar3et Value !alan&e +eet e$am%le ? &ontinue'
@+at +a%%ens to Re "+en 'e t &osts rise>
*0.1910090
100800
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Leverage and Returns
+
=
V
E B
V
D B B
E D A
( ) D A A E B BV D
B B +=
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WACC
@ // is t+e tra'itional vie" of &a%italstru&ture- ris3 an' return.
+
==
V
E r
V
Dr r WACC
E D A
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M&M #roposition ..
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WACC traditional vie'
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