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Capital Structure and Value in the Absence of Taxes

This outline discusses the relationship between capital structure and firm value in the absence of taxes. It examines the impact of debt, corporate taxes, and financial distress on financial choices and value. Additionally, it explores the concepts of assets, liabilities, stockholder's equity, and cash flows in determining the value of a firm.

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Capital Structure and Value in the Absence of Taxes

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  1. Outline 6: Capital Structure • Debt and Value in the Absence of Taxes • Capital Structure and Corporate Taxes • Cost of Financial Distress • Explaining Financial Choices

  2. Value and Capital Structure Assets Liabilities and Stockholder’s Equity Value of cash flows from firm’s real assets and operations Market value of debt Market value of equity Value of Firm Value of Firm

  3. Average Book Debt Ratios

  4. M&M (Debt Policy Doesn’t Matter) • Modigliani & Miller • When there are no taxes and capital markets function well, it makes no difference whether the firm borrows or individual shareholders borrow. Therefore, the market value of a company does not depend on its capital structure.

  5. M&M (Debt Policy Doesn’t Matter) Assumptions Capital structure does not affect cash flows e.g... • No taxes • No bankruptcy costs • No effect on management incentives

  6. M&M (Debt Policy Doesn’t Matter) Example - River Cruises - All Equity Financed

  7. M&M (Debt Policy Doesn’t Matter) Example cont. 50% debt

  8. M&M (Debt Policy Doesn’t Matter) Example - River Cruises - All Equity Financed - Debt replicated by investors

  9. Cost of Capital

  10. Weighted Average Cost of Capital r rE rA rD D V

  11. Weighted Average Cost of Capitalwithout taxes (M&M view) r rE WACC rD D V Includes Bankruptcy Risk

  12. Weighted Average Cost of Capital r rE WACC rD D V

  13. Cap. Struct. And Corp. Taxes Financial Risk - Risk to shareholders resulting from the use of debt. Financial Leverage - Increase in the variability of shareholder returns that comes from the use of debt. Interest Tax Shield- Tax savings resulting from deductibility of interest payments.

  14. Cap. Struct. And Corp. Taxes Example - You own all the equity of Space Babies Diaper Co.. The company has no debt. The company’s annual EBIT is $1,000. The corporate tax rate is 40%. You have the option to exchange 1/2 of your equity position for 10% bonds with a face value of $1,000. Should you do this and why?

  15. C.S. & Corporate Taxes Example - You own all the equity of Space Babies Diaper Co.. The company has no debt. The company’s annual cash flow is $1,000, before interest and taxes. The corporate tax rate is 40%. You have the option to exchange 1/2 of your equity position for 10% bonds with a face value of $1,000. Should you do this and why? All Equity 1/2 Debt EBIT 1,000 Interest Pmt 0 Pretax Income 1,000 Taxes @ 40% 400 Net Cash Flow $600 All Equity 1/2 Debt EBIT 1,000 1,000 Interest Pmt 0 100 Pretax Income 1,000 900 Taxes @ 40% 400 360 Net Cash Flow $600 $540

  16. Total Cash Flow All Equity = 600 *1/2 Debt = 640 (540 + 100) Cap. Struct. and Corp. Taxes Example - You own all the equity of Space Babies Diaper Co.. The company has no debt. The company’s annual cash flow is $1,000, before interest and taxes. The corporate tax rate is 40%. You have the option to exchange 1/2 of your equity position for 10% bonds with a face value of $1,000. Should you do this and why? All Equity 1/2 Debt EBIT 1,000 1,000 Interest Pmt 0 100 Pretax Income 1,000 900 Taxes @ 40% 400 360 Net Cash Flow $600 $540

  17. Capital Structure D x rD x Tc rD PV of Tax Shield = (assume perpetuity) = D x Tc Example: Tax benefit = 1000 x (.10) x (.40) = $40 PV of 40 perpetuity = 40 / .10 = $400 PV Tax Shield = D x Tc = 1000 x .4 = $400

  18. Capital Structure Firm Value = Value of All Equity Firm + PV Tax Shield Example All Equity Value = 600 / .10 = 6,000 PV Tax Shield = 400 Firm Value with 1/2 Debt = $6,400

  19. Financial Distress Costs of Financial Distress - Costs arising from bankruptcy or distorted business decisions before bankruptcy. Market Value = Value if all Equity Financed + PV Tax Shield - PV Costs of Financial Distress

  20. Financial Distress Maximum value of firm Costs of financial distress PV of interest tax shields Market Value of The Firm Value of levered firm Value of unlevered firm Optimal amount of debt Debt

  21. Financial Choices Trade-off Theory - Theory that capital structure is based on a trade-off between tax savings and distress costs of debt. Pecking Order Theory - Theory stating that firms prefer to issue debt rather than equity if internal finance is insufficient.

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