Chapter 17

DOES DEBT POLICY MATTER?

Brealey, Myers, and Allen

Principles of Corporate Finance
11th Global Edition
McGraw-Hill Education Copyright 2014 by The McGraw-Hill Companies, Inc. All rights reserved.
CONTENTS

The effect of financial leverage on firm

value MM Proposition I
Financial risk and expected returns MM
Proposition II
WACC with the presence of leverage
After-tax WACC

17-2
17-1 EFFECT OF FINANCIAL LEVERAGE ON
COMPETITIVE TAX-FREE ECONOMY
MM Proposition 1
When (1) firm pays no taxes and (2) capital
markets function well and (3) the cost of
borrowing is the same for firm and for individual
shareholders, market value of company does
not depend on capital structure.

17-3
17-1 EFFECT OF FINANCIAL LEVERAGE ON
COMPETITIVE TAX-FREE ECONOMY
General proof of MMs Proposition 1

17-4
17-1 EFFECT OF FINANCIAL LEVERAGE ON
COMPETITIVE TAX-FREE ECONOMY
General proof of MMs Proposition 1

17-5
TABLE 17.1 MACBETH SPOT REMOVERS NO
DEBT

17-6
TABLE 17.2 MACBETH SPOT REMOVERS 50%
DEBT

17-7
FIGURE 17.1 BORROWING INCREASES
MACBETHS EPS

17-8
TABLE 17.3 INVESTORS REPLICATE MACBETH'S
LEVERAGE

Shareholders under all-equity-financed firm can replicate the firms leverage by

borrowing on their account. Here the investor is borrowing $10 at 10% and
buying the second share. The investor, by borrowing on his own account, can
replicate the outcome of the levered firm. The firms should have the same value.
17-9
17-2 FINANCIAL RISK AND EXPECTED
RETURNS
Proposition I and Macbeth

17-10
17-2 FINANCIAL RISK AND EXPECTED
RETURNS
Leverage and Returns

17-11
PROPOSITION II

The cost of equity capital is increasing in

the percentage of debt in the capital
structure.
re = ra + (ra rd)(D/E)
where ra is the cost of capital if the firm
were financed entirely with equity.

17-12
17-2 FINANCIAL RISK AND EXPECTED
RETURNS
Proposition II:

If zero leverage:

17-13
17-2 FINANCIAL RISK AND EXPECTED
RETURNS
Proposition II

If firm borrows and becomes a levered firm:

Re increases linearly with D-E ratio (leverage).

17-14
TABLE 17.4 LEVERAGE AND RISK MACBETH
SHARES
MM Prop I says leverage has no effect on firms value. MM Prop II says R(e)
increases in proportion to leverage. Is there a contradiction here?

No. Because increase in Re is exactly offset by an increase in risk that keeps the
value constant.

17-15
EXAMPLE 17.1 LEVERAGE AND COST OF EQUITY

Leverage and Returns

WACC = 12.75%
17-16
17-2 FINANCIAL RISK AND EXPECTED
RETURNS
Now the firm issue 10 debt to retire 10 equity. Leverage
increases. But MM says WACC remain the same at 12.75%.

17-17
17-2 FINANCIAL RISK AND EXPECTED
RETURNS
Beta of asset = weighted average of betas
of individual assets

17-18
17-3 WEIGHTED-AVERAGE COST OF CAPITAL
Weighted-Average Cost of Capital (WACC)

17-19
17-3 WACC: IF Re AND Rd DO NOT CHANGE WITH
LEVERAGE, Ra DECLINES
One possible scenario, re and rd do not change with leverage,
then WACC will decline with leverage.
r
rE

rA = WACC

rD

D
V

17-20
FIGURE 17.2 MM PROPOSITION II: Re AND Rd
CHANGE BUT Ra CONSTANT

17-21
FIGURE 17.3 WACC TRADITIONAL VIEW : Re, Rd
CHANGE, Ra TAKES A U-SHAPE

17-22
17-4 FINAL WORD ON AFTER-TAX WEIGHTED-
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

17-23
17-4 FINAL WORD ON AFTER-TAX WEIGHTED-
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 debt over value ratio of 16%, what is
WACC?
WACC = ((1.35) x 4.7 x .16) + (9.9 x .84)
= 8.8%

17-24
FIGURE 17.4 UNION PACIFIC WACC

17-25
17-4 FINAL WORD ON AFTER-TAX WEIGHTED-
AVERAGE COST CAPITAL
After-Tax WACC
Balance Sheet (Market Value, billions)
Assets 22.6 7.6 Debt
15 Equity
Total assets 22.6 22.6 Total liabilities

Debt ratio = (D/V) = 7.6/22.6 = .34 or 34%

Equity ratio = (E/V) = 15/22.6 = .66 or 66%
Assume: marginal tax rate of 35%, Cost of equity
10.0% and pretax cost of debt 5.5%

17-26
17-4 FINAL WORD ON AFTER-TAX WEIGHTED-
AVERAGE COST CAPITAL
After-Tax WACC

17-27