Chapter 14: M&M Perfect Markets: Learning Objectives

1. Describe securities used to raise capital; define leverage and capital structure
2. List assumptions underlying perfect capital markets
3. Discuss the implications of MM Proposition I, and the roles of homemade
leverage, no arbitrage and Law of One Price
4. Calculate levered cost of equity as per MM Proposition II.
5. Illustrate the effect of change in debt on WACC
6. Examine effect of debt on the beta of levered equity.
7. Understand concept of Debt vs. Net Debt.
8. Discuss the effect of leverage on a firm’s EPS

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 1. Introduction:
■ Three Decisions:

Decision Financial Statement Coverage

1 Investment Balance Sheet: Assets First half of CFIN 1

2 Financing/ Capital Balance Sheet; Liabilities Second half of CFIN 1

Structure/Financial Leverage

3 Operations Income Statement and Finance/Operations and

Cash Flow Statement Other Courses

❑Criteria for Decisions: Value Creation: NPV and IRR

❑ Focus: Effect of Capital Structure (Debt vs. Equity) on the Firm Value
❑Valuation of debt and equity from Investor’s perspective in CFIN2 (Chs.6 and 9)
❑Different types of Debt (chapter 24) and Equity (Chapter 25)
❑Our Focus: Simple Debt and Equity with no special features

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 2. Issues in Financing Decision
A. Two decisions:
■ How much to borrow: Capital Structure Policy (Ch. 14-16) (CFIN 1)
■ How much to retain: Payout/Dividend Policy (Ch.17): Dividend policy
affects Retained Earnings or Equity (CFIN 2)
B. Specific Questions:
1. Does Debt financing create more Value?
2. Effect of debt on the risk of firm, risk of equity and risk of debt?
3. Effect of debt on cost of capital for debt, equity and firm?

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 Symbols and Terms with Definitions
Symbol/Term Definitions/Explanation
Leverage Financing Choice of Debt vs. Equity for investments; Also known as Capital Structure
Unlevered (U) No debt; 100% equity. Also called unlevered equity
Levered A Firm financed by mix of debt and equity
Levered Equity Equity of a firm with debt financing
Beta of Assets βA = βL x E/VL + βD x D/VL = βFirm = βcompany (Example 14.7, p. 539); Also, Ch, 12
Levered Equity Beta βL = βU + (βU – βD) x D/E (see slide 35) = βE (Example 14.7, p. 539); Also Ch. 12
WACC (without taxes) rA = rL x E/VL + rD x D/VL = rU = RF + MRP x βA (Ch. 12 p. 463-465)
Cost of Levered Equity rL= rE = rU + (rU – rD) x D/E = RF + MRP x βE (Ch. 12.1, p. 444)
Cost of Debt rD= RF + MRP x βD (Ch. 12.4, p.453)
βU Beta of Unlevered equity; Usually βU = βA; however, with surplus cash βE < βU (refer to page 540
example 14.8) implying that equity less risky compared to operating assets.
βD and βE βD = Beta of debt; βE = βL = Levered Equity Beta
D = Value of Debt, E = Value of Equity,
VL = Value of Levered Firm = D + E; VU = Value of unlevered firm

MRP Market Risk Premium = (Market Return – Risk Free Rate) (p.447)
Net Debt Debt – Cash (page 76, Example 12.6 on pp. 459 and examples 14.7 and 14.8 on pp. 539-540)

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3. Capital Structure: Basic Issues: A Simple Example
1. Firms U and L have same Total Assets $100 and are in the same business
2. Firm U has no debt and firm L has $ 50 debt @ 5% interest rate and rest equity.
3. Firms U and L have 100 shares and 50 shares respectively.
4. Assume no taxes
5. EBIT distribution same for both firms and will remain constant in perpetuity
Firm U (100 shares) Firm L (50 shares)
1. EBIT $5.00 $10.00 $15.00 $5.00 $10.00 $15.00
2. Probability 1/3 1/3 1/3 1/3 1/3 1/3
3. Interest @ 5% 0.0 0.0 0.0 2.50 2.50 2.50
4. EBT (1-3) $5.00 $10.00 $15.00 2.50 7.50 12.50
5. EPS = EBT/# of shares 0.05 0.10 0.15 0.05 0.15 0.25
Given probabilities and EPS distributions we can compute E(EPS) and  EPS!

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Capital Structure: Basic Issues: A Simple Example
Firms Firm U Firm L
T. Assets 100 Equity 100 Debt 50
Equity 50
# shares 100 50
Price/share $1 ?? equity/shares outstanding= 50/50=1

E (EBIT) $10 $10

E (EPS) 0.10 0.15
 EPS 0.041 0.082
1. EBIT same but U has lower E(EPS) but also lower Standard Deviation.
2. Firm L has higher E(EPS) but also higher Standard Deviation.
3. Price per share for U equals $1; What should be price per share for L?
4. Should the price per share for L be higher than firm U? Why? Why not? no
5. Can Value of equity of L be other than $50? Is arbitrage possible? When? no

6. Should the risk of firm U and L be same or different? Why? different

7. Will the risk of equity for two firms be equal? Different? Why? Why not? different

(c) Surendra Capital Structure Ch 14 6

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 4. Modigliani & Miller in Perfect Markets
1. Free Cash flows come from investment (assets) & operating (use of assets) decisions
2. Financing Decision: Distribution of cash flows between debt & equity (Liability Side)
Assume Perfect Markets: Following assumptions
1. No taxes, transaction cots or issuance (flotation costs) costs
2. No Asymmetric Information (Insiders and outsiders agree on CF estimates)
3. No bankruptcy costs and/or Agency costs
4. Homemade and corporate leverage identical: Investors and firms can trade the same
securities with similar terms and their values equal to the PV of future CFs.
Three Main conclusions:
a. Value of firm independent of capital structure: VU = VL
b. Costs of Equity & Debt increase with leverage due to higher financial risk
rE = rU + (rU – rD) x D/E = RF + MRP x βE
rD = RF + MRP x βD
c. However, WACC remains constant : rU = rL x E/VL + rD x D/VL (Proof in slide 35)

Capital Structure Ch 14 7
 Graphs of M&M Conclusions
Graphical Representation

r V
rE

VL = VU
rU

rD

D/E D/E

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 Homemade and Corporate Leverage Identical
First Numerical Example 1: (Data from slides # 5 and 6)
■ E(EBIT) = $10 and Assets of firms U & L = $100
First option:
1. X invests his own equity $10 to buy 10% of firm U.
2. Y invests her own equity $10 to buy 10% of debt and 10% of equity of firm L

Investor Ownership Investment Total CF Debt CF Equity CF Debt Value Equity Value

X 10% of U $10 $1 0 $1.00 0 $10

Y 10% of firm L $10 $1 0.25 $0.75 $5 ?? 5

1. For X; ROIC = Total CF/Investment = $1.00/10.00 =10% = same as ROE in this case.
2. For Y: ROIC = (Debt CF + Equity CF)/Investment(0.25 + 0.75)/10.0 = 1.0/10.0 =10% =
same as ROE
3. Same CFs and returns must have same value to avoid arbitrage → VU = VL
This is an example of corporate leverage being equal to homemade leverage.
ROE = Return on Equity; ROIC = Return on Invested Capital
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 Homemade and Corporate Leverage Identical:
First Numerical Example 1: (Data from slide # 5 and 6)
E(EBIT) = $10 and Value of firm U $100 but Value of Firm L = ??
Second Option:
1. X invests $10 ($5 of his equity plus borrows $5 @ 5%) to buy 10% of firm U.
2. Y invests $5 equity to buy 10% of Equity of firm L (no debt).
Investor Ownership Investment Equity Total CF Debt CF Equity CF Debt Value Equity Value

X 10% of U with $ 5 debt $10 $5 $1.00 (0.25) $0.75 $5 $5

Y 10% of Equity of L $5 $5 $0.75 0 $0.75 0 ?? 10

1. X: Return to Equity: CF to Equity/Equity = (1.00 – 0.25)/(10.0 – 5.0) = 0.75/5.0 = 15%

2. Y: Return to Equity: 0.75/5.0 = 15%
3. Conclusion: Same CFs (0.75) and returns (15%) must have same value to avoid arbitrage →VU = VL
Individuals can borrow on same terms and conditions as corporations. Personal and Corporate Leverage are identical.

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 Second Numerical Example: (pp.525-36) M&M Perfect Markets
 A promoter has a 1-year project costing $800 with cash flows of either
$1400 (strong economy) or $900 (weak economy) with equal probability.
 Risk free rate = 5% and Risk Premium on such projects = 10%
 Discount Rate for the project = 5% + 10% = 15%.
 E (Cash Flow) = 0.5 x 1400 + 0.5 x 900 = 1150
 PV of Cash Inflows = $1,000 = 1150/1.15
 NPV of project = -800 +1150/1.15 = 200
 $200 goes to promoter!! $ 1,000 is the fair value/price of the project.
 Fair (no arbitrage) price defined as PV of cash flows discounted at risk
adjusted discount rate. Any price other than $1000 results in arbitrage.
 Discount rate estimated directly without CAPM. 10% = βu x MRP; but
we don’t know either βu or MRP.
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 Second Numerical Example: Cont’d…All Equity Financing
■ With 100% equity , how much should investors be willing to pay?
■ In perfect markets equity investors will pay $1,000 (fair price)
■ Expected Equity Return (15%) = Required Return on Equity (15%)
Time = 0 Time = 1: Cash Flows Time = 1: Returns

Investment Strong Weak Strong Weak

Unlevered Equity $1,000 $1,400 $900 40% -10%

E (Return to Equity) = 0.5 x 40% + 0.5 (-10%) = 15%; Also Required Return

1. What if financed $500 by debt?

2. What should be the cost of debt?
3. Should the cost of debt equal risk-free rate? Why? Why not?
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 Second Numerical Example: Some Debt ($500)
Time = 0 Time 1: Cash Flows
Investment Strong Weak
Debt $500 $525 $525
Equity ? $875 $375
Firm $1,000 $1,400 $900
Before M & M: Equity = {0.5 x 875 + 0.5 x 375}/1.15 = $543.

• Is 15% correct discount rate for equity cash flows now? Should equity value be $543?
• Will prospective equity investors pay $543? Why not? This 1.15 is cost of capital when no debt, but now with debt the cost
• Is risk of equity CF same as before?
of capital will increase

• No, equity risk higher because with debt, equity investors not only exposed to project
business risk (same as before), but also to additional financial risk resulting from debt
financing. “Residual Equity CF” with debt are riskier.
• Thus,15% incorrect discount rate with debt. It should be higher. How much?
• 15% appropriate rate for unlevered (all equity) but not for levered equity financing.
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 Second Numerical Example: Some Debt = $500
Time = 0 Time 1: Cash Flows Time 1: Returns
Value Strong Weak Strong Weak Exp. Return
Debt $500 $525 $525 5% 5% 5%
Equity (Levered) $500 $875 $375 75% -25% 25%
Firm/Unlevered Equity/Project $1,000 $1,400 $900 40% -10% 15%

• Firm’s exp. return remains at 15%; but levered equity’s exp. return increases to 25%.
• Some questions:
1. Why is cost of debt still 5%?: What is the risk of the debt investors? Is debt risk free?
2. Are there formula for estimating cost of levered equity (Re) ?: Yes
3. M&M Formula for Re = ru + (ru – rd) x Debt/Equity = 15% + (15% - 5%) x 1 = 25%
4. What if the amount of debt was different?
5. Will the WACC of the firm be different from 15%? no

6. Will the value of firm be higher than $1,000? no

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 Second Numerical Example: Systematic Risk and Risk
Premiums: Debt, Unlevered & Levered Equity
Systematic Risk or Sensitivity of Return Risk Premium
 R = R(strong) – R (Weak) E(R) - Rf
Debt 5% - 5% = 0% 5% - 5% = 0%
Unlevered Equity 40% - (-10%) = 50% 15% - 5% = 10%

Levered Equity 75% - (-25%) = 100% 25% - 5% = 20%

1. Debt return has no sensitivity or systematic risk, its risk premium is zero.
2. Unlevered equity has 50% sensitivity with a risk premium of 10%
3. Levered equity ($500 debt) has 100% sensitivity with a risk premium of 20%
4. Leverage increases risk of levered equity even with risk free debt
5. Even though debt is cheaper, it raises cost of equity. But:
6. With debt: WACC = 0.5 x 25% + 0.5 x 5% = 15% same as before with no debt

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 Second Numerical Example: Varying Debt Levels
E D V = D+E D/E rE rD rWACC = rE x E/V + rD x D/V rWACC
1,000 0 1,000 0.0 15% 5% 1.0 x 0.15 + 0.0 x 0.05 15%
800 200 1,000 0.25 17.5% 5% 0.8 x 0.175 + 0.2 x 0.05 15%
500 500 1,000 1.0 25% 5% 0.5 x 0.25 + 0.5 x 0.05 15%
100 900 1,000 9.0 75% 8.3% 0.1 x 0.75 + 0.9 x 0.083 15%
Some more conclusions and questions:
1. Cost of equity increases with debt due to higher financial risk
2. However, WACC remains constant and is independent of capital structure
3. rWACC = rU = rA = rE x E/V + rD x D/V
4. rE = rU + (rU - rD ) x D/E → For $900 debt: rE = 0.15 + (.15-0.083)x 9/1 = 75%
5. At $900 debt, are debt holders guaranteed full payback? Is the debt Risk-free?
6. Why did rD increase to 8.33%? Is debt risk higher why? Fig. 14.1 page 536; Also see slide #36
7. Until what level of debt should rD remain at 5%?

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 WACC Remains Constant: M&M Proposition II

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 Additional Comments on rE and rD
A. rE Cost of Equity: Three ways to compute (b & c not much used)
a. Use either CAPM or M&M Formula
b. Compute Expected Return (slide # 14)
c. Using Systematic Risk and Risk Premium (Slide # 15)

B. rD Cost of Debt: Three Ways to Compute (Ch. 12 pp. 453-456)

a. Use CAPM but Debt betas may be hard to get
b. Talk to Lender
c. Risk Free Rate plus a spread based on expected Ratings

C. Difference between Promised (16.67%) and Expected (8.33%) cost of debt

a. Promised rate assumes no default. It is same as IRR or Yield to Maturity.
b. Expected rate is based on probability of default
c. In computing WACC we should use Expected Cost
d. For Highly rated debt promised and expected rates are almost equal

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 4 c. Third Numerical Example:
Leveraged Recapitalization: Using CAPM Approach
■ An all equity financed firm has hired you as its new CFO
■ First day on your new job, you are asked to see the CEO.
■ He tells you that firm expects to pay no taxes in near future.
■ Further, he wants your opinion on the following proposal:
1 “We can buy 50% of 10,000 shares by issuing debt.
2 Debt is not only cheaper, but it will also increase EPS.
3 Cost of debt, rD = 10% ; WACC = rU = 20%.
4 bD = .4, bU = bA = 1.2, P/E = 5, RF = 5% and MRP = 12.5%
5 EBIT in perpetuity projected to be $25,000. EBIT=cashflows

6 Final Statement: It seems dumb not to go into debt."

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 Third Numerical Example cont.….
Variable Formula Firm U: No Debt Firm L: 50% Debt

1. # shares 10,000 5,000

2. EPS (EBIT-Interest)/# shares 25,000/10,000 = 2.50 18,750/5000 = 3.75

3. bE bU + (bU – bD) D/E 1.2 1.2+(1.2-.4)x1 = 2.0

4. bU b E x E/V + bD x D/V 1.2 2 x .5 + .4 x .5 = 1.2

5. Cost of equity rE rU + (rU – rD) D/E =RF + . bE x MRP 5% + 1.2 x 12.5% = 20% .2 + (.2 - .1) x 1 = 30%
5% + 12.5% x 2 = 30%
6. WACC rE x E/V + rD x D/V = RF + . bU x MRP 5% + 12.5% x 1.2 = 20% .3 x .5 + .1 x.5 = 20%

7. Value of Equity (E) E = (EBIT – Interest)/rL 25,000/.20 = 125,000 18,750/.30 = 62,500

8. Value of Debt (D) Given Zero 62,500

9. Value of firm (V) V = EBIT/rU 25,000/.20 = 125,000 25,000/.20 = 125,000

10. Price Value of equity/# shares 125,000/10,000 =12.50 62,500/5000 = 12.50

11. P/E Price/EPS 12.50/2.50 = 5 12.50/3.75 = 3.333

1. $62,500 debt: Interest = 62500 x 10% = $6250 and EBT = 25000 – 6250 = 18,750
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 5. Important Learning Takeaways: Summary
1. Value of firm is independent of the capital structure:
a. Firm Value = Debt Value + Equity Value
b. Based on no arbitrage in perfect markets and law of one price.
c. Fair Value = PV of Expected Future Cash Flows
2. Financing decision only distribution of Free CF. Size of pizza (firm
value) can’t increase by slicing it differently (distribution of cash
flows). Hungry Yogi Berra– A baseball great with New York Yankees
3. Beta of levered equity and debt increase with more debt due to
higher financial risk and results in higher costs of equity and debt.
4. However, overall risk of firm (Assets beta)and WACC stay the same
(slide 35 for proof)

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 Two Additional Ideas: Net Debt and Enterprise Value
A: Net Debt: (pp. 459 in BD including example 12.6)
■ Net Debt = Debt – Excess Cash incl. ST Investments
■ Why do we subtract excess cash?
■ Cash includes cash equivalents (e.g., marketable securities)
B. Enterprise value= MV of Equity + MV of Debt – Excess cash
■ Why do we subtract excess cash? (p. 64 in BD)?
■ Is excess cash part of the CF generating operating assets?
■ Can you think of other non-operating assets? e.g., obsolete inventory

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 Cisco with Negative Debt: p. 540 BD ex. 14.8
1. Equity MV = $200 bill.; Debt = $40 bill.; Cash = $75 bill.; and Levered Equity Beta βE= 1.20
2. Assume βD = 0, RF = 2.75% and MRP = 5%
3. MV of Firm = $200 bill + $40bill = $240 bill. =Equity + Debt; It includes cash
4. Net Debt = $40 billions - $75 billions = - $35 billions
5. Enterprise Value = 240B-75B = Equity + Debt – Cash = 200 + 40 – 75 = 165B
6. Alternatively: Equity Value – Excess Cash = 200 bill– 35 bill = $165 billions
7. βU = E/EV x βE + D/EV x βD = 200/(165) x 1.20 -35/(165)x0 = 1.45
8. RU = 2.75% + 1.45 x 5% = 10%
9. RE = 2.75% + 1.20 x 5% = 8.75%
10. WACC = RU = 8.75% x 200/165 + 2.75% x -35.0/165 = 10%
11. RE < RU as βE < βU; Also, we use EV in computing βU
12. Implication: Underlying business of Cisco (1.45) riskier than equity beta (1.2) due to large cash
holding resulting in RE (8.75%) < RU (10%).

(c) Suren
Mansinghka Solution to Blaine Kitchenware case 23
 Two Poems on M&M Propositions
There once was a man named Carruthers
Who kept cows with miraculous udders
He said, “Isn’t this neat?
They give cream from one teat,
And the skim milk from each of the others
■ करो सोने के सौ टु कडे कीमत कम नही ीं होती /
■ Mohabbat Me Sharifon Ki Sharafat Kam Nahi Hoti
By Junaid Sultani

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 6. Capital Structure Fallacies & Extensions
 Fallacy 1: Issuing Debt to buyback Equity raises EPS implying higher value.
More debt also causes higher risk and cost of equity. EPS up by 50% with debt (3.75
vs. 2.50) but rE also higher by 50% (20% to 30%), resulting in same price per share.

 Fallacy 2: Firms should issue Debt as issuing Equity will cause dilution.
Dilution is claimed by asserting that with equity issue, same cash flows are distributed
among more shares causing EPS and value (and price) to be lower. Therefore, to avoid
dilution, firm should use more debt . This ignores that cash raised from equity, if
invested in positive NPV projects should increase values of firm’s and equity.

 Fallacy 3: Repurchasing Equity with Debt will lower WACC and increase value.
More debt causes costs of equity & debt to increase due to higher risk. Leverage has
no effect on WACC which remains unchanged. (see proof slide # 35)

 M & M Propositions are likely to be violated due to

1. Existence of tax (assume corporate tax rate of 30% in Chapter 15)

2. Existence of Cost of bankruptcy and agency costs (Chapter 16)
3. Information asymmetry (Parties have different information) (Chapter 16)

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7. References & Examples: Chapter 14: Perfect Markets
Topic Page Table/Ex./Fig
1 CF & Returns for Levered and Unlevered Equity 525-527 T14.1 -14.3

2 Effect of Leverage on Return and Risk 527-528 T14.4-14.5

3 Leverage and Equity Cost of Capital 528 Ex. 14.1
4 Replicating Levered Equity & Homemade Leverage 530-531 T14.6-14.7

5 Homemade Leverage and Arbitrage 531 Ex. 14.2

6 Leveraged Recapitalization 532-533 T14.9
7 Leverage and Equity Cost of Capital 534-535 Ex. 14.4
8 Leverage, Costs of Debt & Equity & constant WACC 536-537 Fig. 14.1

9 Reducing Leverage and Constant WACC 537 Ex. 14.5

10 Levering and Unlevering Betas 538-539 Ex. 14.7
11 Cash Holdings, Net Debt and Beta 540 Ex. 14.8
12 Leverage and EPS 541-542 Ex. 14.9 & Fig. 14.2

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 Additional Problem # 1

– Suppose in the second numerical example… $1000

project, the entrepreneur borrows $700 to finance
the project. Other data (cash flows 1400 vs. 900,
cost of debt = 5%, Project risk premium =10%)
remain the same. According to Modigliani and Miller,
what should be the value of the equity? What is the
cost of equity or its expected return?

(c) Surendra
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 Solution to Additional Problem # 1 (cont'd)
Because the value of the firm’s total cash flows is still $1000, if the firm
borrows $700, its equity will be worth $300. The firm will owe $700 ×
1.05 = $735 in one year. Thus, if the economy is strong, equity holders will
receive $1400 − 735 = $665, for a return of $665/$300 − 1 = 121.67%.
If the economy is weak, equity holders will receive $900 − $735 = $165,
for a return of $165/$300 − 1 = −45.0%. The equity has an expected
return (Cost of equity) of 1 (121.67%) + 1 ( −45.0%) = 38.33%
2 2
1. Equity has return sensitivity of 121.67% − (−45.0%) = 166.67%; i.e.,
166.67%/50% = 333.34% of the sensitivity of unlevered equity. Therefore, its
risk premium is 38.33% − 5%= 33.33%, which is almost 333.34% of the risk
premium of the unlevered equity, so it is appropriate discount rate for equity.
2. WACC = 5% x 700/1000 + 38.33% x 300/1000 = 15%
3. Debt is at risk-free rate as debt holders will be paid in full. 700 x 1.05 = 735
both under strong and weak economy.
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 Additional Problem # 2
– Suppose there are two firms, each with date 1 cash flows
of $1400 or $900 (as shown in Table 14.1). The firms are
identical in all respects except for their capital structure.
One firm is unlevered, and its equity has a market value of
$1010. The other firm has borrowed $500, and its equity
has a market value of $500. Does MM Proposition I hold?
What arbitrage opportunity is available using homemade
leverage?

(c) Surendra
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 Solution to Additional Problem #2
– MM Proposition I states that the total value of each firm should equal the
value of its assets. Because these firms hold identical assets, their total
values should be the same. However, the problem assumes the unlevered
firm has a total market value of $1,010, whereas the levered firm has a
total market value of $500 (equity) + $500 (debt) = $1,000. Therefore,
these prices violate MM Proposition I, and present an arbitrage
opportunity.
– Because these two identical firms are trading for different total prices, the
Law of One Price is violated, and an arbitrage opportunity exists. To
exploit it, we can buy the equity of the levered firm for $500, and the debt
of the levered firm for $500, re-creating the equity of the unlevered firm
by using homemade leverage for a cost of only $500 + $500 = $1000.
We can then sell the equity of the unlevered firm for $1010 and enjoy an
arbitrage profit of $10.
(c) Surendra
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 Solution to Additional Problem #2 (cont’d)
Date 0 Date 1: Cash Flows
Cash Flow Strong Economy Weak Economy

Buy levered equity -$500 $875 $375

Buy levered debt -$500 $525 $525

Sell unlevered equity $1,010 -$1,400 -$900

Total cash flow $10 $0 $0

Note that the actions of arbitrageurs buying the levered firm’s equity and debt and selling the
unlevered firm’s equity will cause the price of the levered firm’s equity to rise and the price of
the unlevered firm’s equity to fall until the firms’ values are equal.

(c) Surendra
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 Additional Problem #3 with Solution
■ Problem
– Suppose the entrepreneur in Additional Problem # 1 borrows only $400 when
financing the project.
■ Recall, the expected return on unlevered equity is 15% and the risk-free rate is 5%.
– According to MM Proposition II, what will be the firm’s equity cost of capital?
■ Solution
– Because the firm’s assets have a market value of $1000, by MM Proposition I the equity
will have a market value of $600. Then, using Eq. 14.5,
– rE = 15% + (15% -5%) x 400/600 = 21.67%

(c) Surendra
Capital Structure Ch 14 32
Mansinghka
 Additional Problem #4
– Honeywell International Inc. (HON) has a market value debt-equity
ratio of 0.5.
– Assume its current debt cost of capital is 6.5%, and its equity cost of
capital is 14%.
– If HON issues equity and uses the proceeds to repay its debt and reduce
its debt-equity ratio to 0.4, it will lower its debt cost of capital to 5.75%.
– With perfect capital markets, what effect should this transaction have on
HON’s equity cost of capital and WACC?

(c) Surendra
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Mansinghka
 Solution to Additional Problem # 4
Current WACC:
E D 2 1
rwacc = rE + rD = 14% + 6.5% = 11.5%
E+D E+D 2 +1 2 +1
New Equity Cost of Capital:

D
rE = rU + (rU − rD ) = 11.5% + .4(11.5% − 5.75%) = 13.8%
E
New WACC
1 .4
rNEWwacc = 13.8% + 5.75% = 11.5%
1 + .4 1 + .4
Note: While the cost of Equity Capital Decreases from 14% to 13.8% overall WACC
remains unchanged …11.5%

(c) Surendra
Capital Structure Ch 14 34
Mansinghka
 I. MM: Perfect Markets:
Proof that WACC Unaffected by Leverage
■ WACC = rU = rD x D/(D+E) + rE x E/(D+E)
■ Substituting for rD and rE using SML equation
■ rU = {rF + βD(rM– rF)} x D/(D+E) + {rF + βE(rM– rF)} x E/(D+E)

■ rU = rF + {βD x D/(D+E)+ βL x E/(D+E)} x (rM– rF)

■ However: βU = {βD x D/(D+E)+ βL x E/(D+E)}
■ Substituting βU →rU = rF +βU(rM– rF) for levered firm
■ For an unlevered firm: rU = rF +βU(rM– rF)
■ It proves that leverage has no effect on WACC, even
though rD and rL change as values of D and E change.

(c) Surendra
Capital Structure Ch 14 35
Mansinghka
 Explanation of 8.3% and 16.67% in Fig. 14.1 on Page 536
First method: This is simpler and straight forward:
1. For $900 debt (t=0), the payment required (t=1) will be $1,050 = 900x (1.1667)
2. Under strong economy (50% probability) with project cash flows of $1,400 debt holders will
be paid in full (principal, 900, plus interest @ 16.67%) yielding a rate of return of 16.67%.
3. However, under weak economy (50% probability) with project cash flows only of $900, the
debt holders will only get $900 but no interest making their rate of return to be zero.
4. Therefore, the debt holders “expected” return will equal 16.67% x 0.5 + 0% x 0.5 = 8.33%

Second method: Slightly more Complicated:

Cash Flows % Return1 Difference

Item Strong Weak Strong Weak Exp. Col. 4-6 Col. 5-6
(1) Economy Economy Economy Economy Return2
(2) (3) (4) (5) (6)
Project 1,400 900 +40% -10% 15% +25% -25%

Debt 1,050 900 16.67% 0% 8.33% +8.33% -8.33%

1. Recall that project requires investment of $1,000

2. Exp. Return = 0.5 x Return in Strong Economy + 0.5 x Return in Weak Economy
3. Recall that Project has risk premium of 10% for a spread of ± 25% (see above table first row)
4. Therefore, for a spread of ± 8.33% (see above table second row) it should be one third of
10%, or 3.33% because 8.33/25 = 1/3.
5. This gives an “expected” cost of debt = Risk Free Rate + Risk Premium = 5% + 3.33% = 8.33%
6. Alternatively, “expected cost of debt” = 0.5 x 16.67% + 0.5 x 0% = 8.33%
7. See note below to determine why promised rate should be 16.67%.

(c) Surendra
Capital Structure Ch 14 36
Mansinghka