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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
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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
17-10
17-2 FINANCIAL RISK AND EXPECTED
RETURNS
Leverage and Returns
17-11
PROPOSITION II
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17-2 FINANCIAL RISK AND EXPECTED
RETURNS
Proposition II:
If zero leverage:
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17-2 FINANCIAL RISK AND EXPECTED
RETURNS
Proposition II
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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.
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EXAMPLE 17.1 LEVERAGE AND COST OF EQUITY
WACC = 12.75%
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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%.
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17-2 FINANCIAL RISK AND EXPECTED
RETURNS
Beta of asset = weighted average of betas
of individual assets
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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
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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
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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
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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%
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FIGURE 17.4 UNION PACIFIC WACC
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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
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17-4 FINAL WORD ON AFTER-TAX WEIGHTED-
AVERAGE COST CAPITAL
After-Tax WACC
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