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Does Debt Policy Matter?: Principles of Corporate Finance
Does Debt Policy Matter?: Principles of Corporate Finance
1 17-1
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M&M (Debt Policy Doesn’t Matter)
17-3
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M&M (Debt Policy Doesn’t Matter)
17-4
Assumptions
• By issuing 1 security rather than 2, company
diminishes investor choice. This does not reduce
value if:
o Investors do not need choice, OR
o There are sufficient alternative securities
• Capital structure does not affect cash flows, e.g...
o No taxes
o No bankruptcy costs
o No effect on management incentives
Copyright © 2017 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
M&M (Debt Policy Doesn’t Matter)
17-5
Copyright © 2017 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
M&M (Debt Policy Doesn’t Matter)
17-6
Copyright © 2017 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
M&M (Debt Policy Doesn’t Matter)
17-7
Outcomes
A B C D
Operating income $500 1,000 1,500 2,000 Expected
Earnings per share $.50 1.00 1.50 2.00 outcome
Return on shares (%) 5 % 10 15 20
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M&M (Debt Policy Doesn’t Matter)
17-8
Data
Example Number of shares 500
50% debt Price per share $10
Market value of shares $ 5,000
Market value of debt $ 5,000
Outcomes
A B C D
Operating income $500 1,000 1,500 2,000
Interest $500 500 500 500
Equity earnings $0 500 1,000 1,500
Earnings per share $0 1 2 3
Return on shares (%) 0% 10 20 30
Copyright © 2017 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
M&M (Debt Policy Doesn’t Matter)
17-9
Example - Macbeth’s
- All equity financed
- Debt replicated by investors
Outcomes
A B C D
Earnings on two shares $1.00 2.00 3.00 4.00
LESS : Interest @ 10% $1.00 1.00 1.00 1.00
Net earnings on investment $0 1.00 2.00 3.00
Return on $10 investment (%) 0% 10 20 30
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Borrowing and EPS at Macbeth
17-10
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No Magic in Financial Leverage
17-11
MM’s Proposition I
An Everyday Analogy
It should cost no more to assemble a
chicken than to buy one whole
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Proposition I and Macbeth
17-12
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Leverage and Returns
17-13
D E
rA rD rE
DE DE
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M&M Proposition II
17-14
D
rE rA rA rD
E
expected operating income
rE rA
market value of all securities
1500
.15
10,000
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M&M Proposition II
17-15
5000
rE .15 .15 .10
5000
.20 or 20%
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Leverage and Risk
17-16
Operating Income
Change
$1,500 to $500
All equity Earnings per share ($) 1.50 0.50 - $1.00
Return on shares 15% 5% - 10%
50 % debt : Earnings per share ($) 2 0 - $2.00
Return on shares 20% 0 - 20%
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Leverage and Returns
17-17
D E
rA rD
E r
rd = 7.5% D E D E
re = 15% 30 70
rA .075 .15 12.75%
100 100
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Leverage and Returns
17-18
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Leverage and Returns
17-19
D E
BA BD BE
V V
D
BE B A B A BD
V
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WACC
17-20
D E
WACC rA rD rE
V V
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WACC
17-21
rE
rA = WACC
rD
D
V
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M&M Proposition II
17-22
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WACC (traditional view)
17-23
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After-Tax WACC
17-24
D E
WACC rD rE
V V
Old Formula
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After-Tax WACC
17-25
Tax-Adjusted Formula
D E
WACC rD (1 Tc ) rE
V V
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After-Tax WACC
17-26
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After-Tax WACC
17-27
D E
WACC rD (1 Tc ) rE
V V
Copyright © 2017 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
After-Tax WACC
17-28
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Union Pacific WACC
17-29
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After-Tax WACC
17-30
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After-Tax WACC
17-31
MARKET VALUES
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After-Tax WACC
17-32
D E
WACC rD (1 Tc ) rE
V V
Copyright © 2017 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
After-Tax WACC
17-33
D E
WACC rD (1 Tc ) rE
V V
Copyright © 2017 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.