Wm Analysis

The Wm. Wrigley Jr. Company: capital structure,

valuation, and cost of capital

The Effect of Leverage on the Value of the Firm[1]

At the core of many discussions about the motives of leveraged recapitalizations is a set of notions about the impact of leverage on the value of the firm. It is, therefore, necessary to understand both the financial and the operating effects of leverage.

Leverage has two offsetting effects on firm value. The first is the benefit of debt tax shields, literally, the savings in free cash flow owing to a lower tax bill. This savings derives from the deductibility of interest expense from the firm’s taxable income. In the modeling of Nobel Laureates Franco Modigliani and Merton Miller (M&M), the impact of those tax savings is seen in the second term of this equation:

[pic] (1)

This equation says that the value of the levered firm equals the value of the firm as if it were unlevered, plus the present value of debt tax shields, which M&M prove is equal to the tax rate, t, times the amount of debt outstanding, D. The first term of the equation is the present value of the operating cash flows. The second term of the equation, tD, can be viewed as the value effect of the firm’s financing, the present value of the debt tax shields. This equation is the APV method of valuation.

The M&M model was controversial in large part, because it implied that to maximize shareholder value, managers should lever the firm extremely and that to do so would expose the firm to the risk of bankruptcy, which the M&M model did not capture—M&M’s debt was free of default risk. It was relevant over “reasonable” levels of debt, which is why it remains relevant today. But with higher levels of debt, one needed to impose the costs of bankruptcy. This would be like subtracting a third term, C, from Equation 1, to reflect the present value of the expected bankruptcy and the...