Example
The government is lending you \$100,000 for 10 years
at 3% and only requiring interest payments prior to
maturity. Since 3% is obviously below market, what
is the value of the below market rate loan?
repayment loan of PV -
pmts interest of PV - borrowed amount NPV =
Example
The government is lending you \$100,000 for 10 years at 3% and only
requiring interest payments prior to maturity. Since 3% is obviously below
market, what is the value of the below market rate loan?
Assume the market return on equivalent risk projects is 10%.
012 , 43 \$
988 , 56 000 , 100
) 10 . 1 (
000 , 100
) 10 . 1 (
000 , 3
000 , 00 1 NPV
10
10
1
=
− =

(
¸
(

¸

− =

= t
t
Random Walk Theory
• The movement of stock prices from day to day
DO NOT reflect any pattern.
• Statistically speaking, the movement of stock
prices is random (skewed positive over the long term).
Random Walk Theory
\$103.00
\$100.00
\$106.09
\$100.43
\$97.50
\$100.43
\$95.06
Coin Toss Game
Tails
Tails
Tails
Random Walk Theory
S&P 500 Five Year Trend?
or
5 yrs of the Coin Toss Game?
80
130
Month
L
e
v
e
l
Random Walk Theory
S&P 500 Five Year Trend?
or
5 yrs of the Coin Toss Game?
80
130
180
230
Month
L
e
v
e
l
Efficient Market Theory
Last
Month
This
Month
Next
Month
\$90

70

50
Microsoft
Stock Price
Cycles
disappear
once
identified
Actual price as soon as upswing is
recognized
Random Walk Theory
Random Walk Theory
R
e
t
u
r
n

i
n

w
e
e
k

t

+

1
,

(
%
)

Return in week t, (%)
FTSE 100
(correlation = -.08)
Random Walk Theory
R
e
t
u
r
n

i
n

w
e
e
k

t

+

1
,

(
%
)

Return in week t, (%)
Nikkei 500
(correlation = -.06)
Random Walk Theory
R
e
t
u
r
n

i
n

w
e
e
k

t

+

1
,

(
%
)

Return in week t, (%)
DAX 30
(correlation = -.03)
Random Walk Theory
R
e
t
u
r
n

i
n

w
e
e
k

t

+

1
,

(
%
)

Return in week t, (%)
S&P Composite
(correlation = -.07)
Efficient Market Theory
• Weak Form Efficiency
– Market prices reflect all historical information
• Semi-Strong Form Efficiency
– Market prices reflect all publicly available
information
• Strong Form Efficiency
– Market prices reflect all information, both public
and private
Efficient Market Theory
Fundamental Analysts
– Research the value of stocks using NPV and other
measurements of cash flow

Efficient Market Theory
Technical Analysts
– Forecast stock prices based on the watching the
fluctuations in historical prices (thus “wiggle
watchers”)
Efficient Market Theory
-16
-11
-6
-1
4
9
14
19
24
29
34
39
Days Relative to annoncement date
C
u
m
u
l
a
t
i
v
e

A
b
n
o
r
m
a
l

R
e
t
u
r
n

(
%
)
Announcement Date
Efficient Market Theory
-40
-30
-20
-10
0
10
20
30
40
1
9
6
2
1
9
7
7
1
9
9
2
R
e
t
u
r
n

(
%
)
Funds
Market
Average Annual Return on 1493 Mutual Funds and the
Market Index
Efficient Market Theory
0
5
10
15
20
First Second Third Fourth Fifth
A
v
e
r
a
g
e

R
e
t
u
r
n

(
%
)
IPO
Matched Stocks
IPO Non-Excess Returns
Year After
Offering
Efficient Market Theory
2000 Dot.Com Boom
883 , 12
08 . 092 .
6 . 154
) (
2000 March
=

=

=
g r
Div
index PV
589 , 8
074 . 092 .
6 . 154
) (
2002 October
=

=

=
g r
Div
index PV
Lessons of Market Efficiency
Markets have no memory
Trust market prices
There are no financial illusions
The do it yourself alternative
Seen one stock, seen them all

M&M (Debt Policy Doesn’t Matter)
• Modigliani & Miller
– When there are no taxes and capital markets
function well, it makes no difference whether the
firm borrows or individual shareholders borrow.
Therefore, the market value of a company does
not depend on its capital structure.
M&M (Debt Policy Doesn’t Matter)
Assumptions
• By issuing 1 security rather than 2, company
diminishes investor choice. This does not reduce
value if:
– Investors do not need choice, OR
– There are sufficient alternative securities
• Capital structure does not affect cash flows e.g...
– No taxes
– No bankruptcy costs
– No effect on management incentives
M&M (Debt Policy Doesn’t Matter)
Profits 01 . 01V .
urn Dollar Ret Investment Dollar
U
×
L
L L
L
L
01V .
Profits 01 . ) E 01(D . Total
Interest) - Profits ( 01 . 01E . Equity
Interest .01 01D . Debt
urn Dollar Ret Investment Dollar
=
× +
×
×
M&M (Debt Policy Doesn’t Matter)
) .01(V
interest) - Profits ( 01 . 01E .
urn Dollar Ret Investment Dollar
L L
L
D − =
×
Interest) - Profits ( 01 . ) D 01(V . Total
Profits 01 . 01V . Equity
Interest .01 - 01D . Borrowing
urn Dollar Ret Investment Dollar
L U
U
L
× +
×
× −
Example - Macbeth Spot Removers - All Equity Financed
20 15 10 % 5 (%) shares on Return
2.00 1.50 1.00 \$.50 share per Earnings
2,000 1,500 1,000 \$500 Income Operating
D C B A
Outcomes
10,000 \$ Shares of Value Market
\$10 share per Price
1,000 shares of Number
Data
M&M (Debt Policy Doesn’t Matter)
Expected
outcome
Example
cont.
50% debt
M&M (Debt Policy Doesn’t Matter)
30 20 10 0% (%) shares on Return
3 2 1 \$0 share per Earnings
500 , 1 1,000 500 \$0 earnings Equity
500 500 500 \$500 Interest
000 , 2 1,500 1,000 \$500 Income Operating
C B A
Outcomes
5,000 \$ debt of ue Market val
5,000 \$ Shares of Value Market
\$10 share per Price
500 shares of Number
Data
D
Example - Macbeth’s - All Equity Financed
- Debt replicated by investors
30 20 10 0% (%) investment \$10 on Return
3.00 2.00 1.00 0 \$ investment on earnings Net
1.00 1.00 1.00 \$1.00 10% @ Interest : LESS
4.00 3.00 2.00 \$1.00 shares two on Earnings
D C B A
Outcomes
M&M (Debt Policy Doesn’t Matter)
MM'S PROPOSITION I

If capital markets are doing their job,
firms cannot increase value by tinkering
with capital structure.

V is independent of the debt ratio.

AN EVERYDAY ANALOGY
It should cost no more to assemble a
chicken than to buy one whole.
No Magic in Financial Leverage
Proposition I and Macbeth
20 15 (%) share per return Expected
10 10 (\$) share per Price
2.00 1.50 (\$) share per earnings Expected
Equity and Debt Equal
: Structure Proposed
Equity All
: Structure Cuttent
Macbeth continued
Leverage and Returns
securities all of ue market val
income operating expected
r assets on return Expected
a
= =
|
.
|

\
|
+
× +
|
.
|

\
|
+
× =
E D
E
r
E D
D
r r
E D A
M&M Proposition II
15 .
000 , 10
1500
securities all of ue market val
income operating expected
r r
A E
= =
= =
( )
V
D
r r r r
D A A E
− + =
Macbeth continued
M&M Proposition II
15 .
000 , 10
1500
securities all of ue market val
income operating expected
r r
A E
= =
= =
( )
20% or 20 .
5000
5000
10 . 15 . 15 .
=
− + =
E
r
Macbeth continued
( )
V
D
r r r r
D A A E
− + =
Leverage and Risk
20% - 0 20% shares on Return
\$2.00 - 0 2 (\$) share per Earnings : debt % 50
10% - 5% 15% shares on Return
\$1.00 - 0.50 1.50 (\$) share per Earnings equity All
Change
\$500
Income
to \$1,500
Operating
Macbeth continued
Leverage increases the risk of Macbeth shares
Leverage and Returns
Asset Value 100 Debt (D) 40
Equity (E) 60
Asset Value 100 Firm Value (V) 100

r
d
= 7.5%
r
e
= 15%

Market Value Balance Sheet example
% 75 . 12
100
60
15 .
100
40
075 . =
|
.
|

\
|
× +
|
.
|

\
|
× =
|
.
|

\
|
+
× +
|
.
|

\
|
+
× =
A
E D A
r
E D
E
r
E D
D
r r
Leverage and Returns
Asset Value 100 Debt (D) 40
Equity (E) 60
Asset Value 100 Firm Value (V) 100

r
d
= 7.5% changes to 7.875%
r
e
= ??

Market Value Balance Sheet example – continued
What happens to Re when debt costs rise?
% 0 . 16
100
60
100
40
07875 . 1275 .
=
|
.
|

\
|
× +
|
.
|

\
|
× =
e
e
r
r
Leverage and Returns
|
.
|

\
|
× +
|
.
|

\
|
× =
V
E
B
V
D
B B
E D A
( )
D A A E
B B
V
D
B B − + =
WACC
|
.
|

\
|
× +
|
.
|

\
|
× = =
V
E
r
V
D
r r WACC
E D A
 WACC is the traditional view of capital
structure, risk and return.
r
D
V
r
D
r
E
r
E
=WACC
WACC
r
D
E
r
D
r
E
M&M Proposition II
r
A
Risk free debt Risky debt
r
D
V
r
D
r
E
WACC
r
D
V
r
D
r
E
WACC
WACC (M&M view)
After Tax WACC
• The tax benefit from interest expense
deductibility must be included in the cost of
funds.
• This tax benefit reduces the effective cost of
debt by a factor of the marginal tax rate.
|
.
|

\
|
× +
|
.
|

\
|
× =
V
E
r
V
D
r WACC
E D
Old Formula
After Tax WACC
|
.
|

\
|
× +
|
.
|

\
|
× − × =
V
E
r
V
D
Tc r WACC
E D
) 1 (
After Tax WACC
Example - Union Pacific

The firm has a marginal tax rate of 35%.
The cost of equity is 10.0% and the
pretax cost of debt is 5.5%. Given the
book and market value balance sheets,
what is the tax adjusted WACC?
After Tax WACC
Example - Union Pacific - continued
Balance Sheet (Market Value, billions)
Assets 22.6 7.6 Debt
15 Equity
Total assets 22.6 22.6 Total liabilities
MARKET VALUES
After Tax WACC
Example - Union Pacific - continued
|
.
|

\
|
× +
|
.
|

\
|
× − × =
V
E
r
V
D
Tc r WACC
E D
) 1 (
Debt ratio = (D/V) = 7.6/22.6= .34 or 34%

Equity ratio = (E/V) = 15/22.6 = .66 or 66%
After Tax WACC
Example - Union Pacific - continued
|
.
|

\
|
× +
|
.
|

\
|
× − × =
V
E
r
V
D
Tc r WACC
E D
) 1 (
( ) ( )
% 8 . 7
078 .
66 . 10 . 34 . ) 35 . 1 ( 055 .
=
=
+ − × = WACC