DOES DEBT POLICY MATTER?

Transcription

1 Chapter DOES DEBT POLICY MATTER? 17 Brealey, Myers, and Allen Principles of Corporate Finance 11th Global Edition THE QUESTIONS Is it possible to increase the value of the firm by some mix of debt and equity? Modigliani and Miller (1958) said NO, it does not matter What are the pros and cons of equity and debt? (From a pure financing perspective) Equity acts like a buffer for drops in income Debt is good when income is high (no need to share) but bad when income is low (you still have to pay interest) McGraw-Hill Education Copyright 2015 by Bo Sjö and The McGraw-Hill Companies, Inc. All rights reserved LEARNING There some theories. Explain how they are related and what are the implications? Everything starts with M&M The textbook does not present the recent theories well Asymmetric information problem (relates also to principal-agent theories). Next lecture power points. SOME VERY WRONG STATEMENTS Firms should avoid debt totally Firms should be financed with debt only Since a business loan costs 4% in intrest and the required return on equity is 8% you should borrow because it is cheaper to borrow LOOK AT THE BALANCE SHEET Total assets are discounted value of the free cash flows, can this value increase if we change the Debt/equity structure? Can WACC change? Can the Free Cash Flows change? The basic answer is no but why? The extended answer is that maybee there are some links after all. M&M:s provide the answers ENTERS MODIGLIANI & MILLER Modigliani & Miller set up a freecompetition economy where 1. There are no transaction costs 2. There are no taxes and where bankruptcy proceedings are costless (creditors can just take-over) 3. Where every-one has the same information (mangers-shareholdersbond holders)

2 THE COSTOFEQUITYIS NOT GIVEN If a firm financing its expansion with equity only => higher earnings => higher earnings pre share (earnings=dividends, earnings will fluctuate but the firm can pay out as much as it wants from all of its earnings) If the firm borrows money instead the effect is also higher earnings, but since earnings will fluctuate it has consequences for the amount of dividends that can be paid out from the earnings. You must always pay out interest independent of earnings DEBTIS GOODIN GOODTIMES High earnings: With debt: as earnings go up you don t have to share the profit. Share holders are better of. Debt holders get interest nothing more. Low earnings: With debt, as earnings falls low, you have to pay interest first, => less money for dividends FIGURE 17.1 BORROWING INCREASES MACBETH S EPS => EQUITY GETS RISKIER MODIGLIANIAND MILLER With only equity financing: business risk With equity + debt financing: business risk + financial risk M&M show that with borrowing the business risk increases with debt so that the required risk-adjusted return on equity increses 1:1 with higher Debt/Equity M&M PROPOSITION I: CONSTANT WACC WACC remains constant as the shares of debt and equity changes. The expected leveraged earnings increases => Earnings per share increases => The value of the shares cannot increase because the discounted value of earnings per share will remain the same. Thus NO increase in the value of the firm. M&M PROPOSITION II As the share of debt increases so does the required return on equity. Shown by rewriting the WACC formula:

3 ASSET (PORTFOLIO) BETA EQUITY BETA FOR ANYD/E RATIO UNLEVERING EQUITY BETA A USEFUL FORMULA THE M&M PRINCIPLE There no optimal debt/equity ratio D/E doesn t matter, Modigliani has always defened this conclusion More far reaching: A firm should never do for the share holders what they can do for themselves Don t diversify the operations of the firm, the shareholders can diversify on their own. ALL THE DIFFERENT BETA Asset Beta Equity Beta Levered Beta Unlevered Beta (Adjusted Beta)

4 BE AWARE OF BETA The (Equity) Beta you estimate from market data is affected by the firm s D/E ratio. Use M&M prop II to calculate the all-equity Beta.(= Asset Beta=unlevered beta) The mean of all-equity (unlevered) Betas over an industry sector gives the sector Beta. With an all-equity (unlevred) Beta, this all-equity Beta can be relevered to give the Beta for any desiered D/E ratio for a given firm. THE PURE PLAY METHOD TO THE COST OF CAPITAL Instead of using the beta of one firm (say your firm ) Estimate the unlevered Beta for similar firms and calculate the average sector Beta Then do (Ch 19) APV Or, relever this Beta get the relevant cost of equity capital for the specific firm/project you work with. (Given a D/E ratio target) RELAX THE ASSUMPTIONS OF M&M Is there an optimal D/E ratio after all In theory? In practice, what do we know? 17-2 FINANCIAL RISK AND EXPECTED RETURNS Proposition II Given 50/50 - D/E The rest of the slides are text books examples of calculations that I don t present in class The tax deductibility of interest increases the total distributed income to both bondholders and shareholders

5 Example - You own all the equity of Space Babies Diaper Co. The company has no debt. The company s annual cash flow is $900,000 before interest and taxes. The corporate tax rate is 35% You have the option to exchange 1/2 of your equity position for 5% bonds with a face value of $2,000,000. Capital Structure & Corporate Taxes Example - You own all the equity of Space Babies Diaper Co. The company has no debt. The company s annual cash flow is $900,000 before interest and taxes. The corporate tax rate is 35% You have the option to exchange 1/2 of your equity position for 5% bonds with a face value of $2,000,000. Should you do this and why? Total Cash Flow All Equity = 585 Should you do this and why? *1/2 Debt = 620 ( ) PV of Tax Shield = (assume perpetuity) Example: D x r D x Tc r D = D x Tc Tax benefit = 2,000,000 x (.05) x (.35) = $35,000 PV of $35,000 in perpetuity = 35,000 /.05 = $700,000 Firm Value = Value of All Equity Firm + PV Tax Shield Example All Equity Value = 585 /.05 = 11,700,000 PV Tax Shield = 700,000 PV Tax Shield = $2,000,000 x.35 = $700,000 Firm Value with 1/2 Debt = $12,400, AVERAGE COST OF CAPITAL After-Tax WACC Tax benefit from interest-expense deductibility must include cost of funds Tax benefit reduces effective cost of debt by factor of marginal tax rate AVERAGE COST OF CAPITAL Union Pacific Firm has marginal tax rate of 35% Cost of equity 9.9% Pretax cost of debt 4.7% Given book-and-market value balance sheet what is tax-adjusted WACC?

6 AVERAGE COST OF CAPITAL Union Pacific WACC = (1.35) x 4.7 x x.840 = 8.8% After-Tax WACC Kate s Café has marginal tax rate of 35% Cost of equity 10.0% and pretax cost of debt 5.5% Given book- and market-value balance sheets, what is tax-adjusted WACC? After-Tax WACC After-Tax WACC Debt ratio = (D/V) = 7.6/22.6 =.34 or 34% Equity ratio = (E/V) = 15/22.6 =.66 or 66% After-Tax WACC