Principles of Corporate Finance
Brealey and Myers

Sixth Edition
Does Debt Policy Matter?
Slides by
Matthew Will
Irwin/McGraw Hill
Chapter 17
©The McGraw-Hill Companies, Inc., 2000
17- 2
Topics Covered
 Leverage in a Tax Free Environment
 How Leverage Effects Returns
 The Traditional Position
Irwin/McGraw Hill
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17- 3
M&M (Debt Policy Doesn’t Matter)
 Modigliani & Miller

When there are no taxes and capital markets
function well, it makes no difference whether the
firm borrows or individual shareholders borrow.
Therefore, the market value of a company does
not depend on its capital structure.
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17- 4
M&M (Debt Policy Doesn’t Matter)
Assumptions
 By issuing 1 security rather than 2, company
diminishes investor choice. This does not reduce
value if:
 Investors do not need choice, OR
 There are sufficient alternative securities
 Capital structure does not affect cash flows e.g...
 No taxes
 No bankruptcy costs
 No effect on management incentives
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17- 5
M&M (Debt Policy Doesn’t Matter)
Example - Macbeth Spot Removers - All Equity Financed
Data
Number of shares
1,000
Price per share
$10
Market Value of Shares $ 10,000
Outcomes
Operating Income
Earnings per share
Return on shares (%)
Irwin/McGraw Hill
A
B
C
D
$500 1,000 1,500 2,000
$.50 1.00 1.50 2.00
5 % 10
15
20
Expected
outcome
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17- 6
M&M (Debt Policy Doesn’t Matter)
Example
cont.
50% debt
Data
Number of shares
500
Price per share
$10
Market Value of Shares
$ 5,000
Market val ue of debt
$ 5,000
Outcomes
A
Irwin/McGraw Hill
B
C
D
Operating Income
$500 1,000 1,500 2,000
Interest
$500 500
500
Equity earnings
$0
500
1,000 1,500
Earnings per share
$0
1
2
3
Return on shares (%)
0%
15
25
30
500
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17- 7
M&M (Debt Policy Doesn’t Matter)
Example - Macbeth’s
- All Equity Financed
- Debt replicated by investors
Outcomes
A
B
C
D
Earnings on two shares
LESS : Interest @ 10%
Net earnings on investment
$1.00 2.00 3.00 4.00
$1.00 1.00 1.00 1.00
$0
1.00 2.00 3.00
Return on $10 investment (%)
0%
Irwin/McGraw Hill
10
20
30
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17- 8
No Magic in Financial Leverage
MM'S PROPOSITION I
If capital markets are doing their job,
firms cannot increase value by tinkering
with capital structure.
V is independent of the debt ratio.
AN EVERYDAY ANALOGY
It should cost no more to assemble a
chicken than to buy one whole.
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17- 9
Proposition I and Macbeth
Macbeth continued
Expected earnings per share ($)
Price per share ($)
Expected return per share (%)
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Cuttent Structure : Proposed Structure :
All Equity
Equal Debt and Equity
1.50
2.00
10
15
10
20
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17- 10
Leverage and Returns
expected operating income
Expected return on assets  ra 
market val ue of all securities
 D
  E

rA  
 rD   
 rE 
D A
 DE

Irwin/McGraw Hill
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17- 11
M&M Proposition II
Macbeth continued
D
rE  rA  rA  rD 
V
expected operating income
rE  rA 
market val ue of all securities
1500

 .15
10,000
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17- 12
M&M Proposition II
D
rE  rA  rA  rD 
V
Macbeth continued
expected operating income
market val ue of all securities
1500

 .15
10,000
rE  rA 
5000
.15  .10
rE  .15 
5000
 .20 or 20%
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17- 13
M&M Proposition II
r
rE
rA
rD
Risk free debt
Irwin/McGraw Hill
Risky debt
D
E
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17- 14
Leverage and Risk
Macbeth continued
Leverage increases the risk of Macbeth shares
Operating
All equity
Earnings per share ($)
Return on shares
50 % debt : Earnings per share ($)
Return on shares
Irwin/McGraw Hill
Income
$500 $1,500
.50
1.50
5
15
0
0
2
20
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17- 15
Leverage and Returns
 D
  E

BA  
 BD   
 BE 
D A
 DE

D
B E  B A  B A  B D 
V
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17- 16
WACC

WACC is the traditional view of capital
structure, risk and return.
D
 E

WACC  rA    rD     rE 
V
 V

Irwin/McGraw Hill
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17- 17
WACC
Expected
Return
.20=rE
Equity
.15=rA
All
assets
.10=rD
Debt
Risk
BD
Irwin/McGraw Hill
BA
BE
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17- 18
WACC
Example - A firm has $2 mil of debt and
100,000 of outstanding shares at $30 each. If
they can borrow at 8% and the stockholders
require 15% return what is the firm’s WACC?
D = $2 million
E = 100,000 shares X $30 per share = $3 million
V = D + E = 2 + 3 = $5 million
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17- 19
WACC
Example - A firm has $2 mil of debt and 100,000 of outstanding
shares at $30 each. If they can borrow at 8% and the
stockholders require 15% return what is the firm’s WACC?
D = $2 million
E = 100,000 shares X $30 per share = $3 million
V = D + E = 2 + 3 = $5 million
D
 E

WACC    rD     rE 
V
 V

2
 3

   .08     .15 
5
 5

 .122 or 12.2%
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17- 20
WACC
r
rE
rE =WACC
rD
D
V
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17- 21
WACC (traditional view)
r
rE
WACC
rD
D
V
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17- 22
WACC (M&M view)
r
rE
WACC
rD
D
V
Irwin/McGraw Hill
©The McGraw-Hill Companies, Inc., 2000