Long-Term Financial Management
1. Lecture Notes/Comments
In session 6 we cover
(this is a difficult chapter so you will need to apply
yourself diligently this week).
The tax benefit of debt implies that if a firm chooses to
finance itself using debt, it shields part of its income from taxes. In this session we study
the consequent increase in value of the firm. In this session, we focus on three
approaches, Adjusted Present Value, Flow to Equity, and Weighted Average Cost of
Capital. As these approaches have the same logical foundation, they produce identical
estimates of the increase in value of a firm due to the tax benefit of debt.
Adjusted Present Value Approach
The Adjusted Present Value (APV) for a project with debt financing is:
APV = NPV
is the net present value of the project to an all-equity firm:
NPVF is the net present value of financial side effects, which primarily are tax subsidy to
debt and the costs of financial distress arising from the use of debt.
APV has the conceptual advantage of separating the value of the unlevered investment
from the value of financing side-effects.
An Example of APV and the Tax Subsidy to Debt:
Since you are now familiar with the Modigliani-Miller assumptions, the example takes
advantage of the simplicity in the MM world. Suppose PMM, Inc. has an investment that
costs $10,000,000 with expected EBIT (cash flows from operations) of $3,030,303 per
year forever. The investment can be financed either with $10,000,000 in equity or with
$5,000,000 of 10% debt and $5,000,000 of internally generated (equity) cash flows. The
discount rate on an all-equity-financed project in this risk class is 20%. The firm's
marginal tax rate is 34%.
1. All equity value
Annual after tax cash flows to unlevered equity are (EBIT)(1- t
) = ($3,030,303)
(1.34) = $2,000,000. The net present value of the project if financed with internal
equity is therefore:
NPV = ($2,000,000 / .2) – $10,000,000 = $0
Since NPV = $0, the all-equity firm should be indifferent to accepting or rejecting the
2. Financing side effect: Tax Subsidy