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Chp017
1.
Principles of
Corporate Finance Chapter 17 Eighth Edition Does Debt Policy Matter? Slides by Matthew Will McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved
2.
17- 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 McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved
3.
17- 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. McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved
4.
17- 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 McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved
5.
17- 5
M&M (Debt Policy Doesn’t Matter) Rupee Investment Rupee Return .01VU .01× Profits Rupee Investment Rupee Return Debt .01D L .01× Interest Equity .01E L .01× (Profits-Interest) Total .01(D L + E L ) .01× Profits = .01VL McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved
6.
17- 6
M&M (Debt Policy Doesn’t Matter) Rupee Investment Rupee Return .01E L .01× (Profits-interest) = .01(VL − DL ) Rupee Investment Rupee Return Borrowing −.01D L -.01× Interest Equity .01VU .01× Profits Total .01(VU + D L ) .01× (Profits-Interest) McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved
7.
17- 7
M&M (Debt Policy Doesn’t Matter) Example - Macbeth Spot Removers - All Equity Financed Data Number of shares 1,000 Price per share Rs.10 Market Value of Shares Rs. 10,000 Outcomes A B C D Operating Income Rs.500 1,000 1,500 2,000 Expected Earnings per share Rs.0.50 1.00 1.50 2.00 outcome Return on shares (%) 5% 10 15 20 McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved
8.
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M&M (Debt Policy Doesn’t Matter) Example Data Number of shares 500 cont. Price per share Rs.10 50% debt Market Value of Shares Rs. 5,000 Market value of debt Rs. 5,000 Outcomes A B C D Operating Income Rs.500 1,000 1,500 2, 000 Interest Rs.500 500 500 500 Equity earnings Rs.0 500 1,000 1,500 Earnings per share Rs.0 1 2 3 Return on shares (%) 0% 10 20 nn McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved
9.
17- 9
M&M (Debt Policy Doesn’t Matter) Example - Macbeth’s - All Equity Financed - Debt replicated by investors Outcomes A B C D Earnings on two shares Rs.1.00 2.00 3.00 4.00 LESS: Interest @ 10% Rs.1.00 1.00 1.00 1.00 Net earnings on investment Rs.0 1.00 2.00 3.00 Return on $10 investment (%) 0% 10 20 30 McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved
10.
17- 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. McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved
11.
17- 11
Proposition I and Macbeth Macbeth continued Cuttent Structure: Proposed Structure: All Equity Equal Debt and Equity Expected earnings per share (Rs.) 1.50 2.00 Price per share (Rs.) 10 10 Expected return per share (%) 15 20 McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved
12.
17- 12
Leverage and Returns expected operating income Expected return on assets = ra = market value of all securities D E rA = rD × + rE × D+E D+E McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved
13.
17- 13
M&M Proposition II Macbeth continued D rE = rA + ( rA − rD ) V expected operating income rE = rA = market value of all securities 1500 = = .15 10,000 McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved
14.
17- 14
M&M Proposition II D rE = rA + ( rA − rD ) Macbeth continued V expected operating income rE = rA = market value of all securities 1500 = = .15 10,000 5000 rE = .15 + ( .15 − .10) 5000 = .20 or 20% McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved
15.
17- 15
Leverage and Risk Macbeth continued Leverage increases the risk of Macbeth shares Operating Income Change $1,500 to $500 All equity Earnings per share (Rs.) 1.50 0.50 -$1.00 Return on shares 15% 5% -10% 50 % debt: Earnings per share (Rs.) 2 0 -$2.00 Return on shares 20% 0 -20% McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved
16.
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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% D E rA = rD × + rE × re = 15% D+E D+E 40 60 rA = .075 × + .15 × = 12.75% 100 100 McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved
17.
17- 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 = ?? 40 60 .1275 = .07875 × + re × 100 100 re = 16.0% McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved
18.
17- 18
Leverage and Returns D E BA = BD × + BE × V V D BE = B A + ( B A − BD ) V McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved
19.
17- 19
WACC WACC is the traditional view of capital structure, risk and return. D E WACC = rA = rD × + rE × V V McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved
20.
17- 20
WACC r rE rE =WACC rD D V McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved
21.
17- 21
M&M Proposition II r rE rA rD D Risk free debt Risky debt E McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved
22.
17- 22
WACC (traditional view) r rE WACC rD D V McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved
23.
17- 23
WACC (M&M view) r rE WACC rD D V McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved
24.
17- 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. D E WACC = rD × + rE × V V Old Formula McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved
25.
17- 25
After Tax WACC Tax Adjusted Formula D E WACC = rD × (1 − Tc) × + rE × V V McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved
26.
17- 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? McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved
27.
17- 27
After Tax WACC Example – Titan Industries - continued Debt (D ) Rs 318 crores at rD 8.48% Equity (E ) 2443.8 at rE 20% Preference Capital (P) 40 at rP 12% Firm value (V ) Rs 2802 million MARKET VALUES McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved
28.
17- 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% D E P After-tax WACC = rD (1 − Tc ) + rE + rP V V V McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved
29.
17- 29
After Tax WACC Example – Titan Industries - continued D E P WACC = rD (1 − Tc ) + rE + rP V V V After-tax WACC = 0.0848 × (1-0.3366) × 0.11 + 0.12 × 0.02 + 0.2 × 0.87 = 0.1825, or 18.25% McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved
30.
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Web Resources Click to access web sites Internet connection required www.finance.yahoo.com/ www.valuepro.net McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved
Notes de l'éditeur
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