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Principles of Corporate Finance Brealey, Myers, Partington and Robinson 1st Australian Edition Does Debt Policy Matter? Slides by Matthew Will and Graham Partington Irwin/McGraw Hill Chapter 17 ©2000 McGraw-Hill Book Company Australia Pty Ltd PPT t/a Principles of Corporate Finance by Brealey et al 17- Topics Covered Leverage in a Tax Free Environment How Leverage Influences Returns The Traditional Position Irwin/McGraw Hill ©2000 McGraw-Hill Book Company Australia Pty Ltd PPT t/a Principles of Corporate Finance by Brealey et al 17- M&M (Debt Policy Doesn’t Matter) Modigliani & Miller Given investment policy, no taxes and perfect capital markets 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 Put another way, given investment policy, total future cash flow and risk are determined How that total cash flow and risk is packaged between debt and equity doesn’t change the totals so it can’t change total value Irwin/McGraw Hill ©2000 McGraw-Hill Book Company Australia Pty Ltd PPT t/a Principles of Corporate Finance by Brealey et al 17- M&M (Debt Policy Doesn’t Matter) Assumptions By issuing security rather than 2, company diminishes investor choice This does not reduce value if: Investors 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 Irwin/McGraw Hill ©2000 McGraw-Hill Book Company Australia Pty Ltd PPT t/a Principles of Corporate Finance by Brealey et al 17- M&M (Debt Policy Doesn’t Matter) Example - Macbeth Spot Removers - All Equity Financed Data Number of shares 1,000 Price per share $10 Market Value of Shares $ 10,000 Outcomes Operating Income A B C D $500 1,000 1,500 2,000 Earnings per share Return on shares (%) $.50 5% Irwin/McGraw Hill 1.00 10 1.50 15 2.00 20 Expected outcome ©2000 McGraw-Hill Book Company Australia Pty Ltd PPT t/a Principles of Corporate Finance by Brealey et al 17- M&M (Debt Policy Doesn’t Matter) Example cont 50% debt Data Number of shares Price per share 500 $10 Market Value of Shares $ 5,000 Market value of debt $ 5,000 Outcomes A Irwin/McGraw Hill B C D Operating Income Interest $500 1,000 1,500 2,000 $500 500 500 500 Equity earnings Earnings per share $0 $0 500 1,000 1,500 Return on shares (%) 0% 15 20 30 ©2000 McGraw-Hill Book Company Australia Pty Ltd PPT t/a Principles of Corporate Finance by Brealey et al 17- M&M (Debt Policy Doesn’t Matter) Example - Macbeth’s Outcomes - All Equity Financed - Debt replicated by investors Who borrow to finance 50% of their share investment A B C D Earnings on two shares LESS : Interest @ 10% Net earnings on investment $1.00 2.00 3.00 4.00 $1.00 1.00 1.00 1.00 $0 1.00 2.00 3.00 Return on $10 investment (%) 0% Irwin/McGraw Hill 10 20 30 ©2000 McGraw-Hill Book Company Australia Pty Ltd PPT t/a Principles of Corporate Finance by Brealey et al 17- No Magic in Financial Leverage MM'S PROPOSITION I If capital markets are perfect, firms cannot increase value by tinkering with capital structure V is independent of the debt ratio The sum of the parts is equal to the whole VU = VL = E + D Irwin/McGraw Hill ©2000 McGraw-Hill Book Company Australia Pty Ltd PPT t/a Principles of Corporate Finance by Brealey et al 17- Proposition I and Required Returns Macbeth continued Cuttent Structure : Proposed Structure : Expected earnings per share ($) All Equity 1.50 Equal Debt and Equity 2.00 Price per share ($) 10 10 Expected return per share (%) 15 20 Assuming equilibrium expected and required returns are equal Irwin/McGraw Hill ©2000 McGraw-Hill Book Company Australia Pty Ltd PPT t/a Principles of Corporate Finance by Brealey et al 17- 10 Leverage and Returns expected operating income Expected return on assets = = market value of all securities Expected return on assets equals the expected return on the firm’s portfolio of issued securities  D   E  rA = rP =  × rD  +  × rE  D+E  D+E  Irwin/McGraw Hill ©2000 McGraw-Hill Book Company Australia Pty Ltd PPT t/a Principles of Corporate Finance by Brealey et al 10 17- 11 M&M Proposition II By re-arrangement of the last equation: Macbeth continued D rE = rA + (rA − rD ) E When Macbeth is all equity: expected operating income rE = rA = market value of all securities 1500 = = 15 10,000 Irwin/McGraw Hill ©2000 McGraw-Hill Book Company Australia Pty Ltd PPT t/a Principles of Corporate Finance by Brealey et al 11 17- 12 M&M Proposition II D rE = rA + (rA − rD ) E Macbeth continued expected operating income rE = rA = market value of all securities 1500 = = 15 10,000 5000 (.15 − 10) rE = 15 + 5000 = 20 or 20% Irwin/McGraw Hill ©2000 McGraw-Hill Book Company Australia Pty Ltd PPT t/a Principles of Corporate Finance by Brealey et al 12 17- 13 M&M Proposition II r rE rA rD Risk free debt Irwin/McGraw Hill Risky debt D E ©2000 McGraw-Hill Book Company Australia Pty Ltd PPT t/a Principles of Corporate Finance by Brealey et al 13 17- 14 Leverage and Risk Macbeth continued Leverage increases the risk of Macbeth shares Operating Income All equity Earnings per share ($) Return on shares 50 % debt : Earnings per share ($) Return on shares Irwin/McGraw Hill $500 $1,500 50 1.50 15 20 ©2000 McGraw-Hill Book Company Australia Pty Ltd PPT t/a Principles of Corporate Finance by Brealey et al 14 17- 15 Leverage and Returns By analogy with the return equation:  D   E  βA =  × βD  +  × βE  D+E  D+E  D β E = β A + (β A − β D ) E Irwin/McGraw Hill ©2000 McGraw-Hill Book Company Australia Pty Ltd PPT t/a Principles of Corporate Finance by Brealey et al 15 17- 16 Returns and Beta Required Return 20=rE Equity 15=rA All assets 10=rD Debt Risk BD Irwin/McGraw Hill BA BE ©2000 McGraw-Hill Book Company Australia Pty Ltd PPT t/a Principles of Corporate Finance by Brealey et al 16 17- 17 The Traditional Position and WACC WACC is the basis for the traditional view of capital structure, risk and return D  E  WACC = rA =  × rD  +  × rE  V  V  DANGER: Handle WACC with care The objective is NOT to minimise WACC If D/V changes rE changes too Irwin/McGraw Hill ©2000 McGraw-Hill Book Company Australia Pty Ltd PPT t/a Principles of Corporate Finance by Brealey et al 17 17- 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 shareholders 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 = + = $5 million Irwin/McGraw Hill ©2000 McGraw-Hill Book Company Australia Pty Ltd PPT t/a Principles of Corporate Finance by Brealey et al 18 17- 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 shareholders 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 = + = $5 million D  E  WACC =  × rD  +  × rE  V  V   2  3 =  × 08  +  × 15  5  5  = 122 or 12.2% ©2000 McGraw-Hill Book Company Australia Pty Ltd Irwin/McGraw Hill PPT t/a Principles of Corporate Finance by Brealey et al 19 17- 20 Traditional Position and WA r Assuming rE is invariant to leverage: rE rA =WACC Absurd! rD D V Irwin/McGraw Hill ©2000 McGraw-Hill Book Company Australia Pty Ltd PPT t/a Principles of Corporate Finance by Brealey et al 20 17- 21 WACC (traditional view) r Assuming rE is insensitive to moderate levels of D/E rE WACC rD Optimum D/V Irwin/McGraw Hill D E ©2000 McGraw-Hill Book Company Australia Pty Ltd PPT t/a Principles of Corporate Finance by Brealey et al 21 ... McGraw-Hill Book Company Australia Pty Ltd PPT t/a Principles of Corporate Finance by Brealey et al 12 17- 13 M&M Proposition II r rE rA rD Risk free debt Irwin/McGraw Hill Risky debt D E ©2000 McGraw-Hill... McGraw-Hill Book Company Australia Pty Ltd PPT t/a Principles of Corporate Finance by Brealey et al 13 17- 14 Leverage and Risk Macbeth continued Leverage increases the risk of Macbeth shares Operating... McGraw-Hill Book Company Australia Pty Ltd PPT t/a Principles of Corporate Finance by Brealey et al 16 17- 17 The Traditional Position and WACC WACC is the basis for the traditional view of capital structure,
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