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**Unformatted text preview: **1 Valuation and Taxes 2 The Effects of Taxes on Valuation Learning Objectives: 1. Effects of Corporate Taxes on Capital Budgeting 2. Adjusted Present Value (APV) Method 3. Weighted Average Cost of Capital (WACC) 3 1. Introduction Firms can create value by choosing the right financing policy Later in the semester well carefully analyze why and how (capital structure analysis) Now, we focus on the tax effects of financing on valuation of projects Remark It is not the differences in the risk of equity and debt that make the debt/equity mix relevant for valuation It is the fact that cash flows to equity and debt are differently treated for tax purposes that makes the debt/equity mix relevant 4 2. Effects of Corporate Taxes on Capital Budgeting (a) Cash flow effects A projects value depends on its total cash flows (to be shared between creditors and shareholders) Taxes reduce projects total cash flows Since interest payments are treated as an expense, debt financing reduces taxes paid and so increases after-tax total cash flows (tax shields of debt) Useful cash flow decomposition: CF after taxes = Unlevered CF + Tax subsidy due to debt where unlevered CF is the cash flow that would be generated by the project if the firm was all equity financed (i.e., this is simply the free cash flow of the project) 5 How to compute unlevered CF? If the starting point is earnings: Unlevered CF = EBIT + or equivalently, Unlevered CF = Pretax CF - Earnings x Tax Rate + + + rate tax EBIT- Losses Capital Realized Gains Capital Realized- Assets of Sales es Expenditur Capital in Change- Capital in Working Change- on Amortizati and on Depreciati 6 (b) Risk effects Start with CF decomposition : CF after taxes = Unlevered CF + Tax subsidy Risk of tax subsidy of debt is different from the risk of unlevered CF, so we need to discount them at different rates Unlevered CF reflects business risk Tax subsidy is risk-free if EBIT never falls below interest expense. Otherwise it is risky too, but this risk differs from the business risk. What are the proper discount rates for these two components? 7 Liabilities Assets Tax-Savings = TXA Unlevered assets = UA D E We know that Let T C be the corporate tax rate. If debt is static, perpetual, and risk-free, then Since when debt is risk-free we get 1 (1 ) E UA c D T E = +- and hence C C TXA T D UA D E T D = = +- Lets look at firms balance sheet: Real Assets and UA TxA UA TXA D E D E = + + + D E E D D E D E + + + = Assets Financial and , Assets Financial Assets Real = = = D TXA Unlevered beta 8 Why is useful?...

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