Handwaving in Reading 17

The more I think about this reading, the more confused I get. I would think that since required rate of return on equity (Re) increases with levergae (D/E), using M&M from L2, a “safe” firm is the one with a low debt load. However…

Consider a firm with 100% debt = operating assets and no equity. Its beta is zero for equity and operating assets = total assets. Is its WACC really going to be Rf? Because WACC = Rf + beta(op assets) * ERP. Let’s make it even riskier by assuming that now it has a pension plan with assets = operating assets and 100% of its pension plan assets in equity. Total asset beta is still zero, but operating asset beta is now negative (-pension asset beta.) So WACC < Rf?

What kind of wool are they pulling over our eyes here? Maybe M&M were smking something when they asserted that WACC means something and WACC = wdRd(1-t) + weRe.

Merton’s WACC != M&M’s WACC.

If the company has shareholder equity very small and it’s balance sheet is mostly debt what do you think it’s beta will be ? We should look at such a company as junk , low quality , with vey high beta . Remember beta is set by the market setting the risk level for the firm by price volatility . Because of its very high leverage it’s volatility should be thru the roof .

You’re right. I think 100% debt is a special case and should be treated as a singularity because, as you said, the smaller the equity base the larger the beta will be. A company with 1% equity, if it takes the same risks as the market and linearity holds, will make/lose about 100 times as much money as a company with no debt and the same operational leverage. So its beta would be 100.