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Does Debt Policy Matter?

Does Debt Policy Matter?. Student Presentations Capital Structure Considerations Modigliani and Miller – Propositions 1 and 2 Financial Risk and Expected Returns Weighted Average Cost of Capital (WACC) After Tax WACC. Capital Structure. Capital structure is mixture of debt and equity

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Does Debt Policy Matter?

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  1. Does Debt Policy Matter? • Student Presentations • Capital Structure Considerations • Modigliani and Miller – Propositions 1 and 2 • Financial Risk and Expected Returns • Weighted Average Cost of Capital (WACC) • After Tax WACC

  2. Capital Structure • Capital structure is mixture of debt and equity • Firm value is total value of debt plus equity • Types of equity • Common • Preferred • Types of debt • Term • Seniority • Covenants • Hybrids • Convertible bonds

  3. Modigliani and Miller – Proposition 1 • Capital structure does not matter if: • Total cash flows do not change based on capital structure • Markets are perfect • No frictions (taxes or bankruptcy costs) • Corporations have no borrowing advantage • Investors have access to any desired investment • This means that if the capital markets are providing adequate investment choices, then a firm’s value is independent of the debt ratio

  4. Illustration of M&M Prop. 1 Two firms with exactly the same operating income Investor owns 1% of each firm’s securities Firm U is unlevered (all equity) Firm L is levered (has issued debt) Therefore, the value of the two firms must be equal

  5. Another Illustration • Investor owns 1% of levered firm L • Investor owns 1% of unlevered firm U and borrows an amount equal to 1% of the debt of the levered firm • Therefore, the value of the two firms must be equal

  6. Modigliani and Miller's Proposition I states that: A) The market value of any firm is independent of its capital structure B) The market value of a firm's debt is independent of its capital structure C) The market value of a firm's common stock is independent of its capital structure D) All of the above E) None of the above

  7. Law of Conservation of Value • Two streams of cash flow • Stream A has a present value of PV(A) • Stream B has a present value of PV(B) • Value additivity • The present value of the combined cash flows A+B is PV(A) + PV(B) • Conservation of value • Splitting up a cash flow into different parts does not affect the total value of the parts

  8. Example Macbeth Spot RemoversTable 17.1 – All Equity Financed

  9. Table 17.2 – Half Debt/Half Equity

  10. Table 17.3 – All Equity Firm, Investor Leverage to Borrow Enough to Purchase Another Share

  11. The law of conservation of value implies that: A) The value of a firm's common stock is unchanged when debt is added to its capital structure B) The value of any asset is preserved regardless of the nature of the claims against it C) The value of a firm's debt is unchanged when common stock is added to its capital structure D) All of the above E) None of the above

  12. Financial Risk and Expected Returns

  13. M&M Proposition 2 “The expected rate of return on the common stock of a levered firm increases in proportion to the debt-equity ratio (D/E), expresses in market values; the rate of increase depends on the spread between the expected return on a portfolio of all the firm’s securities and the expected return on the debt.”

  14. Illustration of M&M Prop. 2 • Macbeth Spot Removers – All equity • Half debt (at 10% interest) and half equity

  15. Table 17.4 – Financial Leverage Increases Risk

  16. Health and Wealth Company is financed entirely by common stock which is priced to offer a 15% expected return. If the company repurchases 25% of the common stock and substitutes an equal value of debt yielding 6%, what is the expected return on the common stock after refinancing? (Ignore taxes.) A) 12% B) 15% C) 18% D) 21% E) None of the above

  17. How Change in Capital Structure Affects Beta

  18. MM Proposition II states that: A) The expected return on equity is positively related to leverage B) The required return on equity is a linear function of the firm's debt to equity ratio C) The risk to equity increases with leverage D) All of the above E) None of the above

  19. The beta of an all equity firm is 1.1. If the firm changes its capital structure to 1/3rd debt and 2/3rds equity using 8% debt financing, what will be the beta of the levered firm? The beta of debt is 0.3. (Assume no taxes.) A) 1.0 B) 1.1 C) 1.5 D) 1.65 E) None of the above

  20. M&M Proposition II r rE rA rD D E Risk free debt Risky debt

  21. Weighted Average Cost of Capital

  22. Practical Problems with M&M • Unsatisfied clientele • Investors want, and will pay a premium for, securities that offer the particular financial instrument they want (risk, timing, etc.) • Should be a temporary phenomenon • Government regulation • Restrictions on interest rates or available investments • The impact of capital structure on cash flows • Taxation issues • Interest paid on corporate debt is a tax deduction

  23. After-Tax WACC

  24. Next Few Classes • Thursday, April 5 • Case 2 – A-Rod • Case is available in 340 Wohlers • Be prepared to discuss the case in class • Tuesday, April 10 • How much should a firm borrow? – Chapter 18 • Thursday, April 12 • Financing and valuation – Chapter 19

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