Chapter 17 & 18: Debt Policy

What does the M&M proposition 2 say?

The expected rate of return on the shares of a levered firm increases in proportion to the debt-equity ratio.

MM proposition 2 Imagine a firm that is expected to produce a level stream of operating profits. As leverage is increased, what happens to: The ratio of the market value of the firm to income before interest if (i) MM are right and (ii) the traditionalists are right?

(i) Assume MM are correct. The market value of the firm is determined by the income of the firm, not how it is divided among the firm's security holders. Also, the firm's income before interest is independent of the firm's financing. Thus, both the value of the firm and the value of the firm's income before interest remain constant as leverage is increased. Hence, the ratio is constant. (ii) Assume the traditionalists are correct. The firm's income before interest is independent of leverage. As leverage increases, the firm's cost of capital first decreases and then increases; as a result, the market value of the firm first increases and then decreases. Thus, the ratio of the market value of the firm to firm income before interest first increases and then decreases, as leverage increases.

Tax shields "The firm can't use interest tax shields unless it has (taxable) income to shield." What does this statement imply for debt policy? Explain briefly.

A firm with no taxable income saves no taxes by borrowing and paying interest. The interest payments would simply add to its tax-loss carry-forwards. Such a firm would have little tax incentive to borrow.

MM proposition 2 Imagine a firm that is expected to produce a level stream of operating profits. As leverage is increased, what happens to: The ratio of the market value of the equity to income after interest?

As leverage is increased, the cost of equity capital rises. This is the same as saying that, as leverage is increased, the ratio of the income after interest (which is the cash flow stockholders are entitled to) to the value of equity increases. Thus, as leverage increases, the ratio of the market value of the equity to income after interest decreases.

What is the pecking order theory?

As one solution to asymmetric information. Managers prefer internal retained earnings as the first choice as the source of capital to finance new investment, followed by debt financing and finally equity financing.

MM's propositions True or false? Borrowing does not increase financial risk and the cost of equity if there is no risk of bankruptcy.

False (debt amplifies variations in equity income).

MM's propositions True or false? MM's proposition 2 says that the cost of equity increases with borrowing and that the increase is proportional to D/V, the ratio of debt to firm value.

False (the cost of equity increases with the ratio D/E).

MM's propositions True or false? MM's proposition 2 assumes that increased borrowing does not affect the interest rate on the firm's debt.

False (the formula rE = rA + (rA - rD) (D/E) does not require rD to be constant).

MM's propositions True or false? Borrowing always increases firm value if there is a clientele of investors with a reason to prefer debt.

False (value increases only if clientele is not satisfied).

MM's propositions What is wrong with the following argument? A capital investment opportunity offering a 10% internal rate of return is an attractive project if it can be 100% debt-financed at an 8% interest rate.

If the opportunity were the firm's only asset, this would be a good deal. Stockholders would put up no money and, therefore, would have nothing to lose. However, rational lenders will not advance 100% of the asset's value for an 8% promised return unless other assets are put up as collateral. Sometimes firms find it convenient to borrow all the cash required for a particular investment. Such investments do not support all of the additional debt; lenders are protected by the firm's other assets too. In any case, if firm value is independent of leverage, then any asset's contribution to firm value must be independent of how it is financed. Note also that the statement ignores the effect on the stockholders of an increase in financial leverage.

3 parts that are entitled to the value of the company:

If we make the green slice as little as possible, there will be more left over for the shareholders and stockholders. This is done by maximizing the tax shield benefits.

MM's propositions What is wrong with the following argument? Moderate borrowing doesn't significantly affect the probability of financial distress or bankruptcy. Consequently, moderate borrowing won't increase the expected rate of return demanded by stockholders.

Moderate borrowing does not significantly affect the probability of financial distress, but it does increase the variability (and market risk) borne by stockholders. This additional risk must be offset by a higher average return to stockholders.

Tax shields The present value of interest tax shields is often written as TcD, where D is the amount of debt and Tc is the marginal corporate tax rate. Under what assumptions is this present value calculation correct?

The calculation assumes that the tax rate is fixed, that debt is fixed and perpetual, and that investors' personal tax rates on interest and equity income are the same.

What is the tax-deductible interest?

The tax deductibility of interest increases the total income that can be paid out to bondholders and stockholders.

MM proposition 1 "MM totally ignore the fact that as you borrow more, you have to pay higher rates of interest." Explain carefully whether this is a valid objection.

This is not a valid objection. MM's Proposition II explicitly allows for the rates of return for both debt and equity to increase as the proportion of debt in the capital structure increases. The rate for debt increases because the debtholders are taking on more of the risk of the firm; the rate for common stock increases because of increasing financial leverage.

MM's propositions What is wrong with the following argument? The more debt the firm issues, the higher the interest rate it must pay. That is one important reason that firms should operate at conservative debt levels.

This is not an important reason for conservative debt levels. So long as MM's Proposition I holds, the company's overall cost of capital is unchanged despite increasing interest rates paid as the firm borrows more. (However, the increasing interest rates may signal an increasing probability of financial distress—and that can be important.)

What does the M&M theory proposition 1 say about the effect on financial leverage?

This theory is rarely correct, but this is the ideal world. This is under the assumption that the economy has no taxes and well-functioning capital markets. The theory says that the market value of a company does not depend on capital structure. Because there is no difference between a firm borrowing and individual shareholders borrowing. The firm value is independent of the debt ratio. Leverage increases the expected stream of earnings per share but not the share price.

MM's propositions True or false? MM's propositions assume perfect financial markets, with no distorting taxes or other imperfections.

True

MM's propositions True or false? MM's proposition 1 says that corporate borrowing increases earnings per share but reduces the price-earnings ratio.

True (as long as the return earned by the company is greater than the interest payment, earnings per share increase, but the P/E falls to reflect the higher risk).

MM's propositions What is wrong with the following argument? As the firm borrows more and debt becomes risky, both stock- and bondholders demand higher rates of return. Thus, by reducing the debt ratio, we can reduce both the cost of debt and the cost of equity, making everybody better off.

Under Proposition I, the firm's cost of capital (rA) is not affected by the choice of capital structure. The reason the quoted statement seems to be true is that it does not account for the changing proportions of the firm financed by debt and equity. As the debt-equity ratio increases, it is true that both the cost of equity and the cost of debt increase, but a smaller proportion of the firm is financed by equity. The overall effect is to leave the firm's cost of capital unchanged.