Does Debt Policy Matter

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Does Debt Policy Matter?

• Chapter 17

2
Capital Structure

• Mix of debt and equity
• One that maximizes firm value
• All equity
• CFs go to shareholders
• Debt equity
• Two streams of CFs
• Safe stream goes to bondholders
• Risky stream goes to shareholders
• Starting point to understand why capital
  structure does matter
• Modigliani Miller

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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.
• Irrelevant!

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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)

• Set up
• U unlevered firm
• VU EU
• L levered firm
• VL EL DL
• U L have same operating income just different
  capital structures

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MM (Debt Policy Doesnt Matter)
Dont want risk, so buy 1 of U.
Alternative, buy 1 of L (so, D E).
Same payoff. Same cost. So, VU VL.
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MM (Debt Policy Doesnt Matter)
Now, take more risk, so buy 1 of the shares of L.
Alternative, borrow .01DL on own account and
purchase 1 of U. Get inflow of .01DL but pay
interest.
Same payoff. So, VU VL.
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MM (Debt Policy Doesnt Matter)
Example (Prop 1) - 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
Borrow 10 and invest 20 in 2 shares
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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
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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 Propositions

• Proposition 1 Leverage has no effect on
  shareholder wealth
• Proposition 2 rE increases as debt-equity ratio
  increases
• How are shareholders indifferent?
• Increase in expected return is exactly offset by
  an increase in risk and therefore is
  shareholders required rate of return

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Leverage and Risk
Macbeth continued
Leverage increases the risk of Macbeth shares
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Leverage and Returns
Market Value Balance Sheet example
Asset Value 100 Debt (D) 30 Equity
(E) 70 Asset Value 100 Firm Value (V) 100
rd 7.5 re 15
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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 ??
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Leverage and Returns Beta
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Leverage and Returns Beta

• Example Debt beta is .1 and equity beta is 1.1.
  Firm is 30 debt and 70 equity. Find BA.
• Now, refinance so 40 debt. Debt is riskier, so
  debt beta is 0.2. Find BE.
• Thus, borrowing creates financial leverage.

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WACC

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

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WACC
r
rE
rE WACC
rD
D E
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MM Proposition II
r
rE
rA
rD
D E
Risk free debt
Risky debt
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Two Warnings

• Maximizing firm value is NOT always equivalent to
  minimizing the WACC.
• S/h are more interested in being rich than owning
  a firm with a low WACC.
• Minimizing WACC encourages logical short
  circuits
• Ex Debt is cheaper so just borrow more to reduce
  WACC

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WACC (traditional view)
r
rE
WACC
rD
D E
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WACC (MM view)
r
rE
WACC
rD
D E
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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.

Old Formula
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After Tax WACC
Tax Adjusted Formula
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After Tax WACC

• Example - Union Pacific
• The firm has a marginal tax rate of 35. The
  cost of equity is 10.0 and the pretax cost of
  debt is 5.5. Given the book and market value
  balance sheets, what is the tax adjusted WACC?

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After Tax WACC

• Example - Union Pacific - continued

MARKET VALUES
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After Tax WACC

• Example - Union Pacific - continued

Debt ratio (D/V) Equity ratio (E/V)