Lecture 7 - Does debt policy matter? Flashcards
What was MMs first proposition?
The value of a firm is not affected by its capital structure - any combination of securities is as good as another in a perfect capital market
What are the formulas that prove MMs proposition in relation to levered and unlevered firms?
For unlevered firms: E(U)=V(U)
For levered firms: V(L)= E(L)+D(L) or El=V(L)-D(L)
What law does MM’s first proposition represent and what does this state?
The conservation of value
Can slice the cash flow pie into as many slices as we like- but the value will always slice back to the value of the unsliced streatm
What is the argument that is used to prove the first proposition, when it seems as though the EPS will be higher when debt is used (given tax deduct ability of interest)
The argument is that shareholders themselves can replicate the firms financial leverage by borrowing on their own account
- When investors can borrow as EASILY AND CHEAPLY- company borrowing will not increase value and shareholder wealth
What is the formula for calculating the return on the share?
EPS/ price
- When will it not matter whether debt or equity is used in relation to EPS (breakeven Point)
- What will happen if income is higher past breakeven point or lower?
Breakeven point: Market return on assets = interest rate on debt
Formula: Operating Income/ MV of equity
- If the operating income is more than breakeven: the return to shareholders will be increased (EPS increases with more debt)
- If the operating income is less than the breakeven: the return to shareholders will be decreased (EPS decreases with more debt)
Why does the share price not increase when the expected return has increased from more debt?
Due to an increase in risk- the discount rate to be applied for future earnings also increases to exactly offset the increase in expected earnings
What does the MM proposition #2 state?
Which formula do I use?
It states that as as the debt: equity ratio increases, the expected rate of return on equity will also increase - therefore the WACC will remain unchanged
The cost of capital reversed for Re
What is the formula for determining the Re (cost of equity) for a company with all equity?
Expected operating income/ market value of all securities (equity)
Why does the discount rate for earnings also increase when debt is used?
There is an increase in financial risk to shareholders- and therefore shareholders demand a higher “required” rate of return to discount expected earnings:
- If all equity: risk is purely business risk
- If both debt and equity: the range is doubled and additional variability is financial risk
What is the formula for calculating the equity beta?
Be = Ba + (Ba-Bd)*D/E (same as the WACC formula - simply replace all variables with beta)
What will be the impact on the asset beta when there is 50% debt and equity?
The asset beta will double- more risky asset (2x the beta of the asset)
What does the traditional position believe and how does it differ from M&M
Traditionalists - believe the following two instances will occur:
a) If moderate borrowing: Re will increase (but not as much as M&M predict), so Ra and WACC declines at first (due to D/E ratio increasing)
b) If heavy borrowing: Re shoots up faster than M&M predict - so therefore WACC rises with the D/E ratio)
Where is the traditionalists optimal capital structure?
Where the WACC is minimised
What do traditionalists state about corporate borrowing and advantages for investors? How have their perspectives changed?
Stated that investors who wanted to borrowing would buy shares in levered firms rather than personal borrowing (and therefore willing to pay a premium)
- No longer a premium because so many firms are levered now
