WACC and Debt Policy

Optimal Capital Structure?

 M&M (Debt Policy Doesn’t Matter)
• Modigliani & Miller (Proposition I)
– When there are no taxes and capital markets
are perfect, the market value of a company
does not depend on its capital structure.

The Value of the firm does not change with debt:

V L = VU
 Return on Assets (wacc)
No Taxes
expected operating income
Expected return on assets = ra =
market value of all securities

 D   E 
rA =  × rD  +  × rE 
D+E  D+E 

Note: rA = WACC (with no taxes)

 M&M Proposition II

D
rE = rA + ( rA − rD )
E
The cost of equity capital increases with financial
leverage – due to the increase in Risk!

V = D + E
These should be Market values!
 r M&M Proposition II
rE

rA = WACC

rD
D
Risk free debt Risky debt E
 Leverage and Returns
Impact on Beta

 D   E 
BA =  × BD  +  × BE 
D+E  D+E 

D
BE = BA + ( BA − BD )
E
 Leverage and Returns
Impact on Beta
If the Beta of Debt is assumed to be Zero
BD = 0
The Beta of the Levered Firm is Equal to the
Beta of the Unlevered Firm (or Asset Beta) times
One plus the Debt-to-Equity Ratio

D
BL = BU (1 + )
E
Note: Equity betas are levered betas and asset betas are
unlevered betas (L=E and U=A).
 WACC (no taxes)
Ü WACC is the traditional view of capital
structure, risk and return.

D  E 
WACC = rA =  × rD  +  × rE 
V  V 
 Capital Structure
with taxes
D x rD x Tc
 PV of Tax Shield = = D x Tc

(assume perpetuity) rD

Firm Value =
Value of All Equity Firm + PV Tax Shield

V L = VU + T Cx D

MM Proposition I with Corporate Taxes

 MM Prop. I with Taxes
Market Value of The Firm

Value of levered firm

PV of interest
tax shields

Value of
unlevered
firm

Optimal amount
of debt
Debt
 MM with Corporate Taxes
MM Proposition II with Corporate Taxes

D
rE = r0 + (1 − TC )(r0 − rD )
E
r0 = the return on the all equity financed firm (the unlevered
firm or the return on the assets of the firm)
 Debt and Taxes
Impact on Beta
If the Beta of Debt is assumed to be Zero
BD = 0

 D 
BL = BU 1 + (1 − TC ) )
 E 

Remember, βL is the equity beta for a firm with leverage, and

βU is the beta for the firm with NO debt
 r
MM with Taxes: WACC
rE

r
0
WACC

rD
D
V
 Financial Distress
Costs of Financial Distress - Costs arising from


bankruptcy or distorted business decisions before

bankruptcy.


Market Value = Value if all Equity Financed

 + PV Tax Shield
 - PV Costs of Financial Distress
 Financial Distress
Maximum value of firm
Market Value of The Firm

Costs of
financial distress

PV of interest
tax shields
Value of levered firm

Value of
unlevered
firm

Optimal amount
of debt
Debt
 WACC with Taxes
Important: The WACC Formula

D E
WACC = rD (1 − TC ) + rE
V V
Weighted Average Cost of Capital
(with costs of financial distress)
r
rE

WACC

rD
D
Optimal amount V
of debt
 Costs of Debt
• Financial Distress Costs
• Personal Tax Disadvantage of Debt
• Agency Costs
• Information Costs (or Benefits) of Debt
• The Pecking Order Theory
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