In the M&M proposition section (CFAI textbook P122, graph B), how can WACC stay constant while cost of equity capital rises with D/E ratio? Thanks!!!
Because you are getting a bigger tax break for your debt costs (i.e. interest) due to the higher weighting of the tax advantaged debt over equity.
That, and the simple fact that D costs less than E to start with.
lxada269, thanks, I got your point. DarienHacker, I don’t quite understand. Could you elaborate?
Actually, DarienHacker nailed it. The reason that WACC stays constant while Cost of equity rises is that cost of debt is less than cost of equity. To see how this works, look at what happens if Cost of equity stayed constant - as you added debt, the lower cost of debt would result in WACC declining with higher leverage. All M&M did is start with the intuitiion that WACC must be constant because it’s based on the cash flows to the firm (remember that in a world wiithout taxes, if you bought all the claims of the company, you’d get ALL the cash flows from the firm). So, if you get all the cash flows, it doesn;t matter if you get them from the debt or equity side. What M&M did with this idea is to is set up the equations so that the cost of equity rises just enough to offset the fact that you’re adding more and more debt with a lower cost. It was a clever idea, but once you work through the math (if you like that stuff), that’s all it is.
busprof Wrote: ------------------------------------------------------- > Actually, DarienHacker nailed it. > > The reason that WACC stays constant while Cost of > equity rises is that cost of debt is less than > cost of equity. To see how this works, look at > what happens if Cost of equity stayed constant - > as you added debt, the lower cost of debt would > result in WACC declining with higher leverage. > > All M&M did is start with the intuitiion that WACC > must be constant because it’s based on the cash > flows to the firm (remember that in a world > wiithout taxes, if you bought all the claims of > the company, you’d get ALL the cash flows from the > firm). So, if you get all the cash flows, it > doesn;t matter if you get them from the debt or > equity side. > > What M&M did with this idea is to is set up the > equations so that the cost of equity rises just > enough to offset the fact that you’re adding more > and more debt with a lower cost. It was a clever > idea, but once you work through the math (if you > like that stuff), that’s all it is. Can this theory be applied if valuing a company for takeover? If the acquiring company plans on paying off all of the debt of the target company, would this theory be valid?
lxada269 Wrote: ------------------------------------------------------- > > Can this theory be applied if valuing a company > for takeover? If the acquiring company plans on > paying off all of the debt of the target company, > would this theory be valid? Yes, the M&M’s theory can be applied and works as long as you meet its unrealistic assumptions. Then, by removing some assumptions, ou can have something that looks more like real life. For more details, go and visit your books.
olivier Wrote: ------------------------------------------------------- > lxada269 Wrote: > -------------------------------------------------- > ----- > > > > Can this theory be applied if valuing a company > > for takeover? If the acquiring company plans > on > > paying off all of the debt of the target > company, > > would this theory be valid? > > > Yes, the M&M’s theory can be applied and works as > long as you meet its unrealistic assumptions. > > Then, by removing some assumptions, ou can have > something that looks more like real life. > > For more details, go and visit your books. I appreciate the input olivier. FYI, I have been studying the books on this subject (CFAI books) and they do not claim that you should use MM in any situation. They also don’t oppose it. I am not clear on the investment profession’s general consensus about this subject. CFAI prefers the static trade-off theory, but I was curious if anyone still believes MM are correct.
M&M’s true value is not in practice, but as a way of looking at the world. In essence, what it says is that in a world with no “frictions” (i.e. bankruptcy costs, asymmetric information, taxes, etc…) changes in capital structure are irrelevent (i.e. they don’t affect firm value). So, they set up an unrealistic benchmark that serves as a base case. So, if a capital structure change DOES effect value, there must be a “friction” that’s in play (i.e. in the trade-off theory, it’s taxes and financial distress, in the signalling version it’s asymmetric information, and in the agency cost perspective it’s suboptimal investments (wasting cash on negative NPV projects)).
Example 9 on pg 123 gives a clear example of how cost of equity increases with WACC constant.