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Capital Structure II

Capital Structure II. Corporate income taxes. Review question. Describe the two basic capital budgeting decisions. Answer. Project acceptance: each project is independent of others. Each is accepted or rejected.

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Capital Structure II

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  1. Capital Structure II Corporate income taxes

  2. Review question • Describe the two basic capital budgeting decisions.

  3. Answer • Project acceptance: each project is independent of others. Each is accepted or rejected. • Choice between mutually exclusive projects. Of two or more projects, only one can be undertaken.

  4. MM II without taxes • Facts and derivation. • Fact 1: Leverage does not change market value • Fact 2: All cash flows are accounted for.

  5. MM I Cash

  6. rWACC MM Proposition II no tax Cost of capital: r(%) rS . r0 rB Debt-to-equityratio (B/S)

  7. Weighted average cost of capital • The cost to the firm of undertaking a project. • Here independent of leverage … • because leverage doesn’t matter.

  8. Now with taxes. • No threat of bankruptcy. • Corporate taxes, not personal. • Government gets a piece of the pie. • A smaller piece if the firm has debt.

  9. MM I with taxes • VU = market value of the unlevered firm • VL = market value of the levered firm • B = market value of bonds • TC = corporate tax rate • VL = VU + TC B

  10. Why? • Why isn’t the bond rate in the formula? • The bond is a perpetuity. • Market rB is the right discount rate for the perpetuity.

  11. Short derivation • Each year the tax shield is rBTCB • Value of tax shield is • rBTCB/rB = TCB

  12. MM II (with taxes) • Corporate taxes, not personal • rB = interest rate • rS = return on equity • r0 = return on unlevered equity • B = value of debt • SL = value of levered equity • Previously, without taxes rS = r0 + (B/SL)(r0 - rB)

  13. Effect of tax shield • Increase of equity risk is partly offset by the tax shield • rS = r0 + (1-TC)(r0 - rB)(B/SL) • Leverage raises the required return less because of the tax shield.

  14. Cost of capital: r(%) . rS . r0 . . rWACC rB Debt-to-equityratio (B/S) MM II and WACC

  15. WACC not equal to r0. Why? • r0 is the return on unlevered equity. • WACC is for risk like that of the physical asset of the firm. • Adding debt reduces risk of the asset of the firm. • Adding debt reduces WACC. • The levered firm is in a lower risk category.

  16. WACC declines with leverage. • Why? • Because the project is producing bigger interest tax shields, • and the tax shields are a relatively safe asset.

  17. rS increases with leverage. Why? • Leverage raises risk … • and is only partly offset by the tax shield.

  18. A little derivation • Again. Market value equation. • Cash flow equation. • The latter is a version of WACC.

  19. MM I Cash Rewrite cash Sub in MM I

  20. Copying Combine terms Finally

  21. Review question • Does a good project have IRR greater than the hurdle rate, or less?

  22. Answer • IRR is the discount rate that makes NPV(IRR) = 0. • The hurdle rate is the market rate for the risk-class. • Investing means cash flows are first negative, then positive. • Financing (in this context) means cash flows are first positive, then negative.

  23. More answer • Other sign patterns, IRR is not useful. • Investing, a good project has IRR > hurdle rate. • Financing, a good project has hurdle rate > IRR.

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