debt policy

proposition 1 MM

in perfect capital markets, capital structure of a firm doesn’t change firm value. value of firm is determined by real assets, investments, and growth opp, and future cash flow.

it doesnt change total value, just changes how the capital is split up within the firm. law of conservation of value - value of asset preserved. same returns in unlevered and levered firm.

assumptions:
- fully functioning markets
- no taxes
- no bankruptcy/fnancial distress costs
- no effect on managerial incentives
investors have mnay alternatives available so it doesnt matter what company does

investors can replicate what they want from a firm. if they want firm to borrow, they can borrow personally instead of buying shares in a levered firm. same rate, same return overall.
if they want less debt, they can invest in unlevered firm.
this cannot add value bc investors can do it themselevs.
IRL: investors cant usually borrow as cheaply as firms, there are taxes, transaction costs etc.

proposition 2 MM

increasing leverage doesnt change total value, but does increase the expected return of s/h for the increased risk

Ra = Rd (D/V) + Re (E/V)
Re = Ra + (Ra - Rd) (D/E)
before borrowing, D = 0 therefore Re = Ra

graph D/E & rate of return (Ra, Re, Rd) - RISK FREE & RISKY DEBT

tax

tax shield available for interest payments (debt). D/E vs rate of return GRAPH

debt & taxes

debt & taxes have tax shield protection, but increasing more debt is more risky therefore higher chance of financial distress

but need to have enough profits to benefit from tax shield. tax shield sometimes limited to 30% ofEBIT.

value = all equity firm + PV tax shield - financial distress

real example

pharmaceuticals → low debt, intangible assets + PE/VC
utilities, retail → high debt, tangible

PV tax shield

one year = Rd x Tc x D / 1 + Rd
annuity = D / Rd x (1 - 1 / (1 + Rd)t )
perpetuity = Rd x Tc x D / Rd

RAF

( 1 - Tp) / (1 - Tpe) (1 - Tc)

financial distress costs

costs arising from bankruptcy or distorted business decisions before bankruptcy - deter companies from taking adv of tax shield bc borrowing increases risk of financial distress

direct (bankruptcy costs) - legal fees, fire sale discounts (enron 750m in legal costs)
indirect - intanigble assets (people, brand, rep)
agency costs (equity vs debt holders) - managers may make risky decisions that serve s/h

games (risk shifting, refusing to invest, cash in and run, playing for time)

trade off theory

trade off between benefit of tax shield & cost of distress (optimal debt ratio - both offset each other)

pecking order theory

internal → debt → equity
signalling & info asymmetry

evidence

size: larger firms → higher debt
tangible assets → higher debt
market to book (growth) → low debt
profitability → low debt (against trade off theory but for pecking order, have sufficient internal funds)

valuing a business

value = PV FCF + PV terminal value

FCF = EBITDA - tax + dep - investment fixed assets - investment working capital
OR
profit after tax + dep - investment fixed assets - investment working capital

terminal value = FCF (h+1) / WACC - g