Does Debt Policy Matter

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• Does Debt Policy Matter?

Chapter 17
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Topics Covered

• Leverage in a Tax Free Environment
• How Leverage Effects Returns
• The Traditional Position

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MM (Debt Policy Doesnt 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.

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MM (Debt Policy Doesnt 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

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MM (Debt Policy Doesnt Matter)
Example - Macbeth Spot Removers - All Equity
Financed
Expected outcome
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MM (Debt Policy Doesnt Matter)
Example cont. 50 debt
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MM (Debt Policy Doesnt Matter)
Example - Macbeths - All Equity
Financed - Debt replicated by investors
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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.
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Proposition I and Macbeth
Macbeth continued
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Leverage and Returns
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MM Proposition II
Macbeth continued
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MM Proposition II
Macbeth continued
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MM Proposition II
r
rE
rA
rD
D E
Risk free debt
Risky debt
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Leverage and Risk
Macbeth continued
Leverage increases the risk of Macbeth shares
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Leverage and Returns
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WACC

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

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WACC
Expected Return
.20rE
Equity
.15rA
All assets
.10rD
Debt
Risk
BE
BA
BD
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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 stockholders require 15
  return what is the firms WACC?

D 2 million E 100,000 shares X 30 per share
3 million V D E 2 3 5 million
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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 stockholders require 15
  return what is the firms WACC?

D 2 million E 100,000 shares X 30 per share
3 million V D E 2 3 5 million
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WACC
r
rE
rE WACC
rD
D V
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WACC (traditional view)
r
rE
WACC
rD
D V
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WACC (MM view)
r
rE
WACC
rD
D V