chapter13_2a - Chapter 13-2 Capital Structure with Taxes...

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Chapter 13-2: Capital Structure with Taxes and Bankruptcy Costs Understand the impact of taxes and bankruptcy on capital structure choice
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Interest is deductible from corporate taxes, dividends are not deductible Example : Company is considering two ways of financing a project that generates $1,000,000 in pre-tax cash flow each year. Corporate tax rate T C =35% Plan 1: equity finance Plan 2: debt finance with D=4,000,000, r D = 10% Observation: Plan 1 Plan 2 1,000,000 0 1,000,000 (400,000) 1,000,000 (350,000) 600,000 (210,000) 650,000 390,000 Earnings before interest and corporate taxes (EBIT) Interest = r D D Earnings before taxes Taxes Earnings after taxes Total cash flow to all investors- equity and debt Corporate Taxes and Capital Structure
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MM Proposition I with Taxes Annual interest tax shield: An all-equity firm: total cash flow for stockholders: EBIT x (1 – T C ) A levered firm: cash flow for bondholders: r D D cash flow for stockholders: (EBIT–r D D) x (1 – T C ) Total cash flow for stockholders and bondholders: (EBIT–r D D) x (1 – T C ) + r D D = EBIT x (1- T C ) + T C r D D Valuing the interest tax shield: Assume that debt and operating cash flows are perpetual for simplicity. Let V U be value of unlevered firm: (V U = [EBIT x (1-T c )] / r 0 ) Value of stream of annual tax shields: (T C r D D/r D ) = T C D Let V L be value of levered firm: V L = V U + T C D MM Proposition 1 with taxes
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Tax Benefits of Debt Debt (D) Value of firm ( V ) 0 Present value of tax shield on debt Value of firm under MM with taxes and debt V U = Value of firm with no debt
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MM Proposition II with Taxes If firm value increases with debt, WACC must decrease with debt. Relevant formulas are as follows: WACC with taxes: MM proposition II with taxes: r E = r 0 + [(D/E) x (1- T C ) x (r 0 – r D )] E L C D L WACC r V E T r V D r + - = ) 1 (
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Cost of capital with Taxes Debt-to-equity ratio (D/E) Cost of capital: r (%) r 0 r D ) ( ) 1 ( 0 0 D C E r r T E D r r - × - × + = E C D WACC r E D E T r E D D r × + + - × × + = ) 1 (
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This note was uploaded on 06/20/2010 for the course CB EF4441 taught by Professor Professorng during the Spring '10 term at 東京国際大学.

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chapter13_2a - Chapter 13-2 Capital Structure with Taxes...

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