corp_ch19_09

corp_ch19_09 - CLASS NOTES WEEK VII BMA Ch.19 How much...

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IRPGEN424 Corporate Finance Alex Kane 1 CLASS NOTES WEEK VII BMA Ch.19 How much should a firm borrow?
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IRPGEN424 Corporate Finance Alex Kane 2 The objective With perfect markets we found debt didn’t matter Now we sequentially introduce Corporate taxes Bankruptcy costs (BC) Personal taxes Gaming (SH vs DH, corporate governance) Asymmetric information These steps bring us to a more complex and realistic world where the question of how much to borrow cannot be precisely determined These valuation issues are central to corporate finance, financial institutions and asset pricing
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IRPGEN424 Corporate Finance Alex Kane 3 Corp taxes: a pictorial view Operating Income $1 To SH $ 1 to DH Corp tax 0 T C Income after corp tax $1 $1– T C Personal tax 0 0 Income after all taxes $1 $1– T C “LEAKAGE” T C 0 Total = T C Can SH gain from minimizing “leakage”? YES! Maximize debt. IRS
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IRPGEN424 Corporate Finance Alex Kane 4 Equity calculation SH fully own a firm with MV=$100, (V U = E U =$100) generating a perpetuity of $15 • Corp tax: T C =0.35 hence, Perpetual tax = 15*0.35 = $5.25 SH lose to taxes a perpetuity of $5.25 After corporate tax CF = 15 – 5.25 = $9.75 – After-corp tax rate on assets = r A = CF/V U = 9.75% – Since no leverage: r E = r A = 9.75%
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IRPGEN424 Corporate Finance Alex Kane 5 Floating debt (no BC) SH can cash out of the firm $45 by selling debt distributed as special dividend. Assume at this level r D = 5% The perpetual coupon will be: 0.05*45 = $2.25 Interest is tax deductible, the perpetual tax is: (15– 2.25)*0.35 = $4.4625 (savings of 5.25–4.4625= $0.7875) Leverage “cheats” the IRS out of taxes ($0.7875) Debt tax shield = 0.7875 (=r D *D*T C ) as safe as the debt! PV(tax shield) = PVTS = 0.7875/0.05 = $15.75 (=D*T C =45*0.35) Value of firm = V L = V U + PVTS = $115.75 Value of equity = E L = V L D = 115.75 – 45 = $70.75 SH wealth = 70.75 + 45 = 115.75 (increased by PVTS)
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IRPGEN424 Corporate Finance Alex Kane 6 Rates Annual (perpetual) CF to firm = 15–4.4625 = $10.5375 Divided among SH and DH CF to DH (Interest) = 0.45*0.05 = 2.25 CF to SH (Div) = (15–2.25)*(1–0.35) =$8.2875 r E = Div/E = 8.2875/70.75 = 0.1171 D/V=45/115.75=0.3888 (E/V=0.6112, D/E=0.6360) • WACC = r D (1–T C )(D/V) +r E *(E/V) = 0.05*(1–0.35)*0.3888+0.1171*0.6112 = 0.0126 + 0.0716 = 0.0842 < 0.0975 for U Notice also: Unlevered CF / WACC = 9.75/0.0842 =115.75 = V L r E = r A +(r A r D )*(1–T C )*D/E=0.0975+0.0475*0.636=0.1171
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IRPGEN424 Corporate Finance Alex Kane 7 Rates in a world WITH corporate taxes D/E Required returns r D r A r E effect of possible bankruptcy (1–T C )r D wacc with corp taxes Notes: (1) purple lines - with taxes. (2) the world with taxes is D A wacc no taxes
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IRPGEN424 Corporate Finance Alex Kane 8 Can we increase the take from the IRS? Sure!
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corp_ch19_09 - CLASS NOTES WEEK VII BMA Ch.19 How much...

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