DEBT POLICY

Assets Value of Cashflows from the firm`s real assets and operations Value of firm

Liabilities and Stockholders` Equity Market Value of Debt Market Value of Equity Value of firm

Modigliani and Millers Argument

MM proposition I (Debt irrelevance proposition): When there are no taxes and capital markets function well, the market value of a company does not depend on its capital structure. In other words, financial managers cannot increase value by changing the mix of securities used to finance company

Restructuring: Process of changing the firm`s capital structure without changing its assets.
Hence Rassets = (rdebt x D/V) + (Requity x E/V)

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Data Number of Shares Price per share Market value of Shares

100,000.00 10.00 1,000,000.00 State of the Economy Slump Normal Boom 75,000 125,000 175,000 0.75 1.25 1.75 7.50% 12.50% 17.50% Expected outcome

Operating Income Earnigns per Share Return on Shares

If company uses 500,000 of Debt and buy back shares worth 500,000
Data Number of Shares Price per share Market value of Shares Market value of Debt - 10% 50,000.00 10.00 500,000.00 500,000.00 State of the Economy Slump Normal Boom 75,000 125,000 175,000 50,000 50,000 50,000 25,000 75,000 125,000 0.50 1.50 2.50 5.00% 15.00% 25.00% Expected outcome

Operating Income/EBIT Interest Net Income Earnigns per Share Return on Shares

In order words MM`s Proposition I states that the value of the firm must be unaffected by its Capital Structure
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Business Risk
Risk in firm`s operating income. Demand variability Sales price variability Input cost variability Ability to develop new products Foreign exchange exposure Operating leverage (fixed vs variable costs)

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Financial Leverage
Debt financing to amplify the effects of changes in operating income on the returns to stockholders
Advantages of Debt: Interest is tax deductible (lowers the effective cost of debt) Debt-holders are limited to a fixed return so stockholders do not have to share profits if the business does exceptionally well Debt holders do not have voting rights Disadvantages of Debt: Higher debt ratios lead to greater risk and higher required interest rates (to compensate for the additional risk)
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Financial Risk
The additional risk placed on the common stockholders as a result of the decision to finance with debt. Debt finance does not affect the operating risk but its does add financial risk.

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Modigliani and Millers Argument

MM proposition II : The required rate of return on equity increases as the firm`s debt-equity ratio increases. Expected return on equity Expected return on assets DebtExpected Expected equity return on return on + ratio x assets x debt

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But !
Debt Financing has one important advantage: The interest that the company pays is tax-deductible expense but equity income is subject to corporate tax.

Expected Operating Income Debt interest at 10% Before-tax Income Tax at 35% After-tax Income Combined Debt+equity income (Debt Interest + after-tax income)

Zero Debt $500,000 of Debt 125,000 125,000 50,000 125,000 75,000 43,750 26,250 81,250 48,750 81,250 98,750

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Cost of Financial Distress

Cost arising from bankruptcy or distorted business decisions before bankruptcy

Overall Market Value = Value if all-equity financed + PV tax Shield PV cost of financial Distress

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Interest Tax Shield

Tax savings resulting from deductibility of interest payments.
Zero Debt $500,000 of Debt Expected Operating Income 125,000 125,000 Debt interest at 10% 50,000 Before-tax Income 125,000 75,000 Tax at 35% 43,750 26,250 After-tax Income 81,250 48,750 Combined Debt+equity income (Debt Interest + after-tax income) 81,250 98,750 Interest Tax Shield 17,500 Annual Tax Shields = Corporate Tax Rate x Interest Payment = Tc x (rdebt x D)

PV tax Shields = Annual Tax Shield Rdebt Value of levered firm = value if all-equity financed + Present Value of Tax Shield
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