SFU Bus413 Fall 2011

Does Debt Policy Matter?

Lecture 14
Chapter 17
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Topics Covered
Leverage in a Competitive Tax Free Environment
Modigliani-Miller theorem 1
Financial Risk and Expected Returns
and Modigliani-Miller theorem 2

The Weighted Average Cost of Capital

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Motivation
Financing: Your firm needs to raise capital for a
major new investment.
Should it obtain financing through the issuance of new
debt? New equity? What kind of debt? What kind of
equity? How will the stock market react your decision?
What price should the levered equity sell for? Which is
the best capital structure choice for the entrepreneur?
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Why Capital Structure is Irrelevant (for the
Firm Value)
The main conclusion of this chapter: in perfect
capital markets, capital structure does not affect
the firms market value.
Intuition:
The value of the firm is determined by the value of the
assets (the left half of the balance sheet)
The value of the assets is the sum of the DCFs of the
project
The discount rate is also determined by asset (projects)
characteristics because the cost of capital is determined by
asset characteristics
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The Modigliani-Miller Theorem I
Assumptions
Assume Perfect Capital Markets
1. No taxes
2. No transactions costs.
3. Firms cash flows and decisions are not affected
by the choice of financial structure.
4. Symmetric information.
No agency costs
5. No arbitrage (prices are fair, equal to PV of
future cash flows).
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Assumptions 1, 2, and 4
No taxes.
No costs of financial distress or bankruptcy costs.
No issuance costs.
No security trading costs.

Symmetric information: Every agent has the
same information. Nobody knows more than
anybody else.

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Assumption 3 means
(Assumption 3: Firms cash flows and decisions are not
affected by the choice of financial structure)

Financial structure does not affect
investment policy of the firm.
managerial effort.
corporate governance, compensation of management,
and managerial behavior.
bargaining power of firm.
competitive dynamics between firms.
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The Modigliani-Miller Theorem I
ASSUME:
1. No taxes
2. No transactions costs.
3. Firms cash flows and decisions are not affected by the choice of
financial structure.
4. Symmetric information.
5. No arbitrage

THEN: The total market value of the firm is not
affected by how the firm is financed.

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Intuition and Implications of M&M I
The size of a pie is independent of how it is sliced

Value comes from project choice on the LHS of
the balance sheet (from project CFs), not from
financing on the RHS of the balance sheet

The value of an asset is preserved regardless of
the type of claims against it (debt or equity)


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Intuition of M&M 1 : pie theory
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Derivation of M&M1
(Can We Create Value by Splitting a Pie?)
11
U L
V V =
1) Let V
U
be the value of unlevered firm; it is equal to earnings (EBIT).

D r D r EBIT
is ers stakehold all to flow cash total the Thus,
D D
+ ) (
The PV of this stream of cash flows is the value of levered firm V
L
.
EBIT D r D r EBIT
Clearly
D D
= + ) (
Consequently,
D r EBIT
D
D r
D
2) In a levered firm, Shareholders receive Bondholders receive
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All Equity Financed
20 15 10 % 5 (%) shares on Return
2.00 1.50 1.00 $.50 share per Earnings
2,000 1,500 1,000 $500 Income Operating
D C B A : Outcomes

10,000 $ Shares of Value Market
$10 share per Price
1,000 shares of Number
Data
The
Expected
outcome
Effect of Debt on EPS
Example: Macbeth Spot Removers
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13
Issue $5000
debt and
repurchase
500 shares,
i.e., do Leveraged
Recapitalization.
Result:
50% Debt,
50% Equity.

Let r
d
= 10%.

30 20 10 0% (%) shares on Return
3 2 1 $0 share per Earnings
500 , 1 1,000 500 $0 earnings Equity
500 500 500 $500 Interest
000 , 2 1,500 1,000 $500 Income Operating
C B A
Outcomes
5,000 $ debt of ue Market val
5,000 $ Shares of Value Market
$10 share per Price
500 shares of Number
Data
D
Example - Macbeth (contd.)
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14
Example - Borrowing and EPS at Macbeth
Borrowing increases expected EPS when
Income is greater than $1000. Borrowing
decreases expected EPS when Income is
less than $1000.
The steeper black line means the
same fluctuations in OI lead to
greater fluctuations in EPS in the
more levered firm, i.e. EPS are
riskier in the levered firm.
Leverage increases the risk of
equity, even when there is no risk
that the firm can default. Thus,
while debt may be cheaper than
equity, its use raises the cost of
capital for equity.
Expected
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Homemade Leverage: Intuition for M&M
Homemade Leverage
When investors use leverage in their own portfolios to
adjust the leverage choice made by the firm.
MM demonstrated that if investors would prefer an
alternative capital structure to the one the firm has
chosen, investors can borrow or lend on their own
and achieve the same result.
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Debt replicated by investors.
- The Firm is All Equity Financed;
- Borrow $10 and invest $20 in two shares.
30 20 10 0% (%) investment on Return
3.00 2.00 1.00 0 $ investment on earnings Net
1.00 1.00 1.00 $1.00 10% @ Interest : LESS
4.00 3.00 2.00 $1.00 shares two on Earnings
D C B A
Outcomes
Homemade Leverage. Macbeth Example
The 20% return here is the same as for the levered firm.
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Leverage increases the risk of the firms equity.
Investors in a levered firm will require a higher
expected return to compensate for the increased risk.
MMs first proposition can be used to derive an
explicit relationship between leverage and the equity
cost of capital (which is MM Proposition 2).
Start with definitions.
Note that the numerator below is often just Net Income
The Effect of Leverage on Risk and Return
securities all of value market
income operating expected
= = =
A
r ROA assets on return Expected
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equity of value market
income operating expected
= = =
E
r ROE equity on return Expected
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From


obtain

Derivation of
Modigliani-Miller Proposition II
|
.
|

\
|
+
+
|
.
|

\
|
+
=
E D
E
r
E D
D
r r
E D A
18
( )
E
D
r r r r
D A A E
+ =
Since assets=equity in an unlevered firm, the return on
unlevered equity r
U
in this firm is the return on assets: r
U
= r
A
.
Then the return on levered equity r
E
is
( )
E
D
r r r r
D U U E
+ =
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The relation between Leverage and the Equity
Cost of Capital
MM Proposition II:
The cost of capital of levered equity is equal to the cost of
capital of unlevered equity plus a premium that is
proportional to the market value debt-to-equity ratio.
Cost of Capital of Levered Equity
Modigliani-Miller II (cont'd)
( )
E
D
r r r r
D U U E
+ =
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The amount of the premium depends on the amount of leverage,
measured by the firms market value debt-equity ratio, D/E.
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M&M Proposition II in action: Macbeth
20
15 .
000 , 10
1500
r r
A U
= =
= =
securities all of value market
income operating expected
( )
20% or 20 .
5000
5000
10 . 15 . 15 .
=
+ =
E
r
Expected return on unlevered equity:
Expected return on levered equity:
( )
E
D
r r r r
D U U E
+ =
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Leverage and Risk: Macbeth Example
21
Leverage increases not only the return, but also the risk of
Macbeth shares (If OI declines, ROE declines by more in a
levered firm):
Scenario:
Operating Income Decline
Changes
From: $1500 To: $500
All equity
EPS ($) 1.50 0.50
Return on
equity
15% 5% -10%
50% debt
EPS ($) 2 0
Return on
equity
20% 0 -20%
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Leverage and Returns.
Example: Increasing Leverage may affect r
d

% 75 . 12
100
70
15
100
30
5 . 7 =
|
.
|

\
|
+
|
.
|

\
|
=
|
.
|

\
|
+
+
|
.
|

\
|
+
=
A
E D A
r
E D
E
r
E D
D
r r
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Asset Value 100 Debt (D) 30
Equity (E) 70
Asset Value 100 Firm Value (V) 100

Let r
d
= 7.5%, and r
e
= 15%.
Market Value Balance Sheet
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Leverage and Returns Example (contd.)
% 0 . 16
100
60
100
40
875 . 7 75 . 12
=
|
.
|

\
|
+
|
.
|

\
|
=
e
e
r
r
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What happens to r
e
when the firm borrows more, resulting in a
higher cost of borrowing? - Let r
d
= 7.5% change to 7.875%.
r
e
= ??
Market Value Balance Sheet
Asset Value 100 Debt (D) 40
Equity (E) 60
Asset Value 100 Firm Value (V) 100

Both required returns on debt and equity increase.
Note that r
A
is constant above because assets are unaffected.
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Unlevered Firms
Weighted Average Cost of Capital
If a firm is unlevered, all of the free cash
flows generated by its assets are paid out to
its equity holders.
The market value, risk, and cost of capital for the firms
assets and its equity coincide, and therefore,
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U A
r r =
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Levered Firms
Weighted Average Cost of Capital
If a firm is levered, project return r
A
is equal to the
firms weighted average cost of capital.
Weighted Average Cost of Capital (No Taxes) definition





We also know that COC of assets is
Therefore,
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|
.
|

\
|
+
+
|
.
|

\
|
+
=
E D
E
r
E D
D
r r
E D A
U A WACC
r r r = =
|
.
|

\
|
+
+
|
.
|

\
|
+
=
E D
E
r
E D
D
r r
E D WACC
SFU Bus413 Fall 2011
Leverage and WACC (cont'd)
With perfect capital
markets, a firms
WACC is independent
of its capital structure
and is equal to its
equity cost of capital if
it is unlevered, which
matches the cost of
capital of its assets.

Debt-to-Value Ratio - the
fraction of a firms enterprise
value that corresponds to
debt.
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UE A WACC
r r r = =
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Cost of Equity, Cost of Debt, and the WACC:
MM II assuming No Corporate Taxes
Debt-to-equity
Ratio
C
o
s
t

o
f

c
a
p
i
t
a
l
:

r

(
%
)

r
U

r
D

E D WACC
r
E D
E
r
E D
D
r
+
+
+
=
) (
D U U E
r r
E
D
r r + =
r
D

E
D
Assume (just for now) that debt is risk-free: r
d
does not
increase with leverage.
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r
D
E
r
D
r
E
M&M Proposition II with Risky Debt (r
D
changes
with leverage)
r
WACC
=r
A
Risk free
debt
Risky debt
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Levered and Unlevered Betas
The effect of leverage on the risk of a firms securities can also be
expressed in terms of betas:

=

+

+

+

Unlevered Beta (|
U
or |
UE
)
A measure of the risk of a firm as if it did not have leverage, which
is equivalent to the beta of the firms assets: |
A
=|
U

If your goal is to estimate the beta for an investment
project, first, you should calculate the unlevered betas of
firms with comparable investments (using the formula
above). Then apply the effects of your firms leverage:

+(

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Example: Unlevered Beta
Problem
You are managing a food company. Estimates of equity
betas and market debt-equity ratios for several
comparable stocks are shown below.
Which firm has riskier assets?
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Name Equity Beta Debt-Equity Ratio Debt Beta
Kraft Foods Inc. 0.65 0.35 0.10
H.J. Heinz Co. 0.79 2.23 0.27
Lancaster Colony 0.87 0.00 0.00
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Example: Unlevered Beta
Solution
Since

(Assets=Equity in a firm with no debt), we just need to

calculate the unlevered beta for each of the firms.

=

+

+

+

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Name Equity Beta E/(E+D) Debt Beta D/(E+D)
U
=
A

Kraft Foods Inc. 0.65 74.07% 0.10 25.93% 0.51
H.J. Heinz Co. 0.79 30.96% 0.27 69.04% 0.43
Lancaster Colony 0.87 100.00% 0.00 0.00% 0.87
The upshot: levered equity beta

is not appropriate to compare risk

across firms; we need to remove the effects of financing, i.e. unlever the
betas.
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MM and (Unsatisfied) Clienteles (p.432)
If corporations can borrow more cheaply than some
individual investors, the perfect market assumptions are
violated. Then, there can be a clientele of such investors
who would pay a premium for shares of levered firms.

17.5.f. Borrowing increases the firm value if there is a clientele of
investors with a reason to prefer debt.
True or False?

Unsatisfied clienteles appear due to temporary market
imperfections (e.g., interest-rate ceilings, constraints for
small investors, which lead to temporary profits from
issuing additional debt in floating-rate notes, creation of
money market funds).
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Summary. M&M without Taxes
In a world of no taxes and perfect capital markets, the
value of the firm is unaffected by capital structure.
This is M&M Proposition I:
V
L
= V
U



In a world of no taxes, M&M Proposition II states that
leverage increases the risk and return to stockholders


E
D
r r r
E
D
r r r r
D U U D A A E
+ = + = ) ( ) (