debt policy final

7/24/2019 Debt Policy Final

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DEBT POLICYDEBT POLICY


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CHAPTER 22 Dividend Policy 22 - 3

Modigliani and Millers Argument

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:rocess of changing the firm!s capital structure without

changing its assets.

"ence #assets$ %rdebtx &'() * %#e+uityx '()

MM proposition I De!t irrelev"nce proposition#:


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Data

Number of Shares 100,000.00

Price per share 10.00

Market value of Shares 1,000,000.00 State of the Economy

Slump Normal Boom

Operating Income 7,000 1!,000 17,000

"arnigns per Share 0.7 1.! 1.7

#eturn on Shares 7.0$ 1!.0$ 17.0$

Expected outcome


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CHAPTER 22 Dividend Policy 22 - $

Data

Number of Shares 0,000.00

Price per share 10.00

Market value of Shares 00,000.00

Market value of %ebt & 10$ 00,000.00

State of the Economy

Slump Normal Boom

Operating Income'"(I) 7,000 1!,000 17,000

Interest 0,000 0,000 0,000

Net Income !,000 7,000 1!,000

"arnigns per Share 0.0 1.0 !.0

#eturn on Shares .00$ 1.00$ !.00$

Expected outcome

I% co&p"ny uses $''(''' o% De!t "nd !uy !"c) s*"res +ort* $''('''

In order +ords MM,s Proposition I st"tes t*"t t*e v"lue o% t*e %ir&

&ust !e un"%%ected !y its C"pit"l tructure


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22 - .

#isk in firm!s operating income.

- &emand variability

- ales price variability- Input cost variability

-Ability to develop new products

- /oreign exchange exposure

- 0perating leverage %fixed vs variable costs)

1usiness #isk1usiness #isk


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22 - /

%ebt financing to amplif* the effects of changes in operatingincome on the returns to stockhol+ers

/inancial 2everage/inancial 2everage

Advantae! of De"t#

Interest is ta- +e+uctible lo/ers the effective cost of +ebt

%ebt&hol+ers are limite+ to a fi-e+ return so stockhol+ers +o not have to

share profits if the business +oes e-ceptionall* /ell

%ebt hol+ers +o not have voting rights

D$!advantae! of De"t#

2igher +ebt ratios lea+ to greater risk an+ higher re3uire+ interest rates to

compensate for the a++itional risk


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22 - 0

/inancial #isk/inancial #isk

)he a++itional risk place+ on the common stockhol+ers as a

result of the +ecision to finance /ith +ebt. %ebt finance +oes not

affect the operating risk but its +oes a++ financial risk.


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Modigliani and Millers Argument

3he re+uired rate of return on e+uity increases as the firm!s debt4e+uity

ratio increases.

MM proposition II :

Expectedreturn on

e%u$ty &

Expectedreturn on

a!!et! '

De"t(e%u$tyrat$o x

Expectedreturn on

a!!et! (

Expectedreturn on

de"t


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CHAPTER 22 Dividend Policy 22 - '

1ut 5

De"t )$nanc$n ha! one $mportant advantae# The $ntere!t that the company pay! $!

tax(deduct$"le expen!e "ut e%u$ty $ncome $! !u"*ect to corporate tax+


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CHAPTER 22 Dividend Policy 22 -

6ost of /inancial &istress

6ost arising from bankruptcy or distorted business decisions before bankruptcy

Overall Market 4alue 5 4alue if all&e3uit* finance+ 6 P4 ta- Shiel+ P4 cost of financial %istres


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Interest 3ax hield

3ax savings resulting from deductibility of interest payments.

(alue of levered firm $ value if all4e+uity financed * resent (alue of 3ax hield

debt policy final

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