Lect 13 221 web

Lect 13 221 web - Managerial Finance Lecture 13 Valuation...

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1 Managerial Finance Lecture 13 Valuation with Leverage
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2 Class 12: Summary The required return on debt is lower than the required return on equity: Debt is senior Modigliani-Miller (M&M) irrelevance results. Under perfect capital markets: 1. Leverage does not increase firm value 1. Leverage (debt financing) increases the risk of equity 2. The benefit of debt’s lower cost is exactly offset by the higher equity cost of capital (higher equity risk) 2. The WACC is unaffected by financing M&M: the capital structure benchmark M&M: focus on the key source of value Cash flows, cash flows, cash flows! Not : number of shares, earnings per share, expected returns, etc 2
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3 Beyond M&M Capital structure decisions seem to matter. Evidence: Stock prices react to financing decisions • Increase if firms: increase leverage • Decrease if firms: decrease leverage Corporations spend resources on capital structure design • Ex. Investment banking fees Managers are very reluctant to change them: • Tell a CFO that debt policy does not matter M&M does not predict any patterns for capital structure But, capital structure shows lots of patterns • Across time for a given firm: life cycle • Across industries: different asset characteristics • Across countries: different institutional factors 3
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4 MM relied on perfect or frictionless capital markets Leverage and Taxes MM relied on MM: any capital structure is as good as any other ! Thus, capital structure must matter due to some market imperfection : Corporate income taxes Bankruptcy costs Agency costs (incentives) Differences in information Security mispricing 4 Corporate income taxes: Can leverage be used to reduce the corporate income taxes that the firm must pay, and thereby increase its value for investors ?
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5 The Corporate Income Tax Income Statement 2007 2008 2009 2010 2011 Sales Revenues 4,405 4,669 4,985 5,347 5,747 Cost of Goods Sold -2,908 -3,059 -3,240 -3,448 -3,679 SG&A Expenses -705 -747 -797 -856 -920 Interest expenses deducted before tax Depreciation -132 -140 -149 -160 -172 Operating Income 660 724 799 883 976 Other Income 13 10 15 20 24 EBIT 673 734 814 903 1,000 Interest Expense -65 -65 -80 -100 -100 5 Income Before Tax 608 669 734 803 900 Taxes (35%) -213 -234 -257 -281 -315 Net Income 395 435 477 522 585 No corresponding deduction for dividends or share repurchases
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6 Gain from Leverage With vs Without Leverage (2011 With vs. Without Leverage (2011) All Equity Firm Levered Firm EBIT $1000 $1000 Interest Paid to Debt Holders $0 $100 Pre-Tax Income $1000 $900 What is the benefit ? Total income to all investors: All equity firm = $650 Tax at 35% $350 $315 Net Income to Equity $650 $585 $585 Levered Firm $650 All Equity Firm (equity) 6 • Levered firm = 100 + 585 = $685 Gain from leverage = 685 – 650 = $35 Tax savings = 350 – 315 = $35 $100 $685 (debt)
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7 The Interest Tax Shield Debt gives the firm an “ interest tax shield ” which reduces taxes each year: Tax reduction = Corporate Tax Rate Interest Payments This tax shield: Reduces the taxes paid by the firm Increases the net-of tax cash-flows available to both debt and equity Increases the value of the firm: PV(future interest tax shields) = T c PV(future interest payments) T c : corporate tax rate 7
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Lect 13 221 web - Managerial Finance Lecture 13 Valuation...

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