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\
|
+
+
|
.
|
\
|
+
=
E D
E
r
E D
D
r r
E D A
18
( )
E
D
r r r r
D A A E
+ =
Since assets=equity in an unlevered firm, the return on
unlevered equity r
U
in this firm is the return on assets: r
U
= r
A
.
Then the return on levered equity r
E
is
( )
E
D
r r r r
D U U E
+ =
SFU Bus413 Fall 2011
The relation between Leverage and the Equity
Cost of Capital
MM Proposition II:
The cost of capital of levered equity is equal to the cost of
capital of unlevered equity plus a premium that is
proportional to the market value debt-to-equity ratio.
Cost of Capital of Levered Equity
Modigliani-Miller II (cont'd)
( )
E
D
r r r r
D U U E
+ =
19
The amount of the premium depends on the amount of leverage,
measured by the firms market value debt-equity ratio, D/E.
SFU Bus413 Fall 2011
M&M Proposition II in action: Macbeth
20
15 .
000 , 10
1500
r r
A U
= =
= =
securities all of value market
income operating expected
( )
20% or 20 .
5000
5000
10 . 15 . 15 .
=
+ =
E
r
Expected return on unlevered equity:
Expected return on levered equity:
( )
E
D
r r r r
D U U E
+ =
SFU Bus413 Fall 2011
Leverage and Risk: Macbeth Example
21
Leverage increases not only the return, but also the risk of
Macbeth shares (If OI declines, ROE declines by more in a
levered firm):
Scenario:
Operating Income Decline
Changes
From: $1500 To: $500
All equity
EPS ($) 1.50 0.50
Return on
equity
15% 5% -10%
50% debt
EPS ($) 2 0
Return on
equity
20% 0 -20%
SFU Bus413 Fall 2011
Leverage and Returns.
Example: Increasing Leverage may affect r
d
% 75 . 12
100
70
15
100
30
5 . 7 =
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=
|
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|
\
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+
+
|
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|
\
|
+
=
A
E D A
r
E D
E
r
E D
D
r r
22
Asset Value 100 Debt (D) 30
Equity (E) 70
Asset Value 100 Firm Value (V) 100
Let r
d
= 7.5%, and r
e
= 15%.
Market Value Balance Sheet
SFU Bus413 Fall 2011
Leverage and Returns Example (contd.)
% 0 . 16
100
60
100
40
875 . 7 75 . 12
=
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|
\
|
+
|
.
|
\
|
=
e
e
r
r
23
What happens to r
e
when the firm borrows more, resulting in a
higher cost of borrowing? - Let r
d
= 7.5% change to 7.875%.
r
e
= ??
Market Value Balance Sheet
Asset Value 100 Debt (D) 40
Equity (E) 60
Asset Value 100 Firm Value (V) 100
Both required returns on debt and equity increase.
Note that r
A
is constant above because assets are unaffected.
SFU Bus413 Fall 2011
Unlevered Firms
Weighted Average Cost of Capital
If a firm is unlevered, all of the free cash
flows generated by its assets are paid out to
its equity holders.
The market value, risk, and cost of capital for the firms
assets and its equity coincide, and therefore,
24
U A
r r =
SFU Bus413 Fall 2011
Levered Firms
Weighted Average Cost of Capital
If a firm is levered, project return r
A
is equal to the
firms weighted average cost of capital.
Weighted Average Cost of Capital (No Taxes) definition
We also know that COC of assets is
Therefore,
25
|
.
|
\
|
+
+
|
.
|
\
|
+
=
E D
E
r
E D
D
r r
E D A
U A WACC
r r r = =
|
.
|
\
|
+
+
|
.
|
\
|
+
=
E D
E
r
E D
D
r r
E D WACC
SFU Bus413 Fall 2011
Leverage and WACC (cont'd)
With perfect capital
markets, a firms
WACC is independent
of its capital structure
and is equal to its
equity cost of capital if
it is unlevered, which
matches the cost of
capital of its assets.
Debt-to-Value Ratio - the
fraction of a firms enterprise
value that corresponds to
debt.
26
UE A WACC
r r r = =
SFU Bus413 Fall 2011
27
Cost of Equity, Cost of Debt, and the WACC:
MM II assuming No Corporate Taxes
Debt-to-equity
Ratio
C
o
s
t
o
f
c
a
p
i
t
a
l
:
r
(
%
)
r
U
r
D
E D WACC
r
E D
E
r
E D
D
r
+
+
+
=
) (
D U U E
r r
E
D
r r + =
r
D
E
D
Assume (just for now) that debt is risk-free: r
d
does not
increase with leverage.
27
SFU Bus413 Fall 2011
28
r
D
E
r
D
r
E
M&M Proposition II with Risky Debt (r
D
changes
with leverage)
r
WACC
=r
A
Risk free
debt
Risky debt
28
SFU Bus413 Fall 2011
Levered and Unlevered Betas
The effect of leverage on the risk of a firms securities can also be
expressed in terms of betas:
=
+
+
+
Unlevered Beta (|
U
or |
UE
)
A measure of the risk of a firm as if it did not have leverage, which
is equivalent to the beta of the firms assets: |
A
=|
U
If your goal is to estimate the beta for an investment
project, first, you should calculate the unlevered betas of
firms with comparable investments (using the formula
above). Then apply the effects of your firms leverage:
+(
29
SFU Bus413 Fall 2011
Example: Unlevered Beta
Problem
You are managing a food company. Estimates of equity
betas and market debt-equity ratios for several
comparable stocks are shown below.
Which firm has riskier assets?
30
Name Equity Beta Debt-Equity Ratio Debt Beta
Kraft Foods Inc. 0.65 0.35 0.10
H.J. Heinz Co. 0.79 2.23 0.27
Lancaster Colony 0.87 0.00 0.00
SFU Bus413 Fall 2011
Example: Unlevered Beta
Solution
Since
=
+
+
+
31
Name Equity Beta E/(E+D) Debt Beta D/(E+D)
U
=
A
Kraft Foods Inc. 0.65 74.07% 0.10 25.93% 0.51
H.J. Heinz Co. 0.79 30.96% 0.27 69.04% 0.43
Lancaster Colony 0.87 100.00% 0.00 0.00% 0.87
The upshot: levered equity beta