DEBT POLICY

Modigliani and Millers Argument

MM proposition I (Debt irrelevance proposition):
When there are no taxes and capital markets function well, the market
value of a company does not depend on its capital structure. In other
words, financial managers cannot increase value by changing the mix of
securities used to finance company
Restructuring: Process of changing the firm`s capital structure without
changing its assets.
Hence Rassets = (rdebt x D/V) + (Requity x E/V)

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Data
NumberofShares
Pricepershare
MarketvalueofShares

OperatingIncome
EarnignsperShare
ReturnonShares

100,000.00
10.00
1,000,000.00

State of the Economy

Slump
Normal
Boom
75,000
125,000
175,000
0.75 1.25 1.75
7.50%
12.50%
17.50%
Expected outcome

If company uses 500,000 of Debt and buy back shares worth 500,000
Data
NumberofShares
Pricepershare
MarketvalueofShares
MarketvalueofDebt-10%

OperatingIncome/EBIT
Interest
NetIncome
EarnignsperShare
ReturnonShares

50,000.00
10.00
500,000.00
500,000.00
State of the Economy

Slump
Normal
Boom

75,000 125,000 175,000

50,000 50,000 50,000

25,000 75,000 125,000

0.50 1.502.50

5.00%
15.00%
25.00%
Expected outcome

In order words MM`s Proposition I states that the value of the firm
must be unaffected by its Capital Structure
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Business Risk
Risk in firm`s operating income.

Demand variability
Sales price variability
Input cost variability
Ability to develop new products
Foreign exchange exposure
Operating leverage (fixed vs variable costs)

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Financial Leverage
Debtfinancingtoamplifytheeffectsofchangesinoperating
incomeonthereturnstostockholders
Advantages of Debt:
Interestistaxdeductible(lowerstheeffectivecostofdebt)
Debt-holdersarelimitedtoafixedreturnsostockholdersdonothaveto
shareprofitsifthebusinessdoesexceptionallywell
Debtholdersdonothavevotingrights
Disadvantages of Debt:
Higherdebtratiosleadtogreaterriskandhigherrequiredinterestrates(to
compensatefortheadditionalrisk)
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Financial Risk
The additional risk placed on the common stockholders as a
resultofthedecisiontofinancewithdebt.Debtfinancedoesnot
affecttheoperatingriskbutitsdoesaddfinancialrisk.

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Modigliani and Millers Argument

MM proposition II :
The required rate of return on equity increases as the firm`s debt-equity
ratio increases.
Expected
return on
equity

Expected
return on
assets

DebtExpected
Expected
equity
return on
return on
+ ratio x
assets debt

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But !
Debt Financing has one important advantage: The interest that the company pays is
tax-deductible expense but equity income is subject to corporate tax.

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Cost of Financial Distress

Cost arising from bankruptcy or distorted business decisions before bankruptcy

OverallMarketValue=Valueifall-equityfinanced+PVtaxShieldPVcostoffinancialDistress

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Interest Tax Shield

Tax savings resulting from deductibility of interest payments.

Value of levered firm = value if all-equity financed + Present Value of Tax Shield
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