Corp2022fch4ndoc 19 the high debt case aftertax

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19
The High-debt case:
Aftertax operating income
(1) = Net income + Interest - Interest tax shield
= 9,100 + 2,000 - 2,000 × 0.35 = 10,400
(2) = Net income + after-tax interests
= 9,100 + 2,000 × (1-0.35) = 10,400
- a formal proof:
Aftertax operating income of the firm
= Net income + Interest - Interest tax shield
= (EBIT - Interests - Tax) + Interest - Interest tax shield
= EBIT - Tax - Interest tax shield
= EBIT - (EBIT - Interest) × T
C
- Interest × T
C
= EBIT - EBIT × T
C
+ Interest × T
C
- Interest × T
C
= EBIT - EBIT × T
C
= EBIT × (1-T
C
)
Note:
It shows that the aftertax operating income of the firm is independent of
the firm's financial policy (i.e., the use of debt)
Accounting Rates of Return
- EVA: a dollar measure

subject to the scale of the firm

" profits per dollar
of assets"
- a digression:
Excess measure = observed measure - benchmark measure
Excess return = observed return - benchmark return

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1. Return on Capital (ROC)
% 0 . 17
520 , 21
658 , 3
tion capitaliza total
income operating aftertax
   ROC
% 4 . 9 7.6% - 17.0%
capital of cost - % 0 . 17 return Excess
 

% 4 . 29 % 6 . 7 0 . 17 capital of %cost
capital of %cost
tion capitaliza total
income operating aftertax
tion capitaliza total
tion capitaliza Total capital of %cost - income operating aftertax
tion capitaliza total
EVA
    
 


ROC
ROC based on another measure of total capitalization:
% 4 . 16
2 / ) 172 , 233 520 , 21 (
658 , 3
tion capitaliza total average
income operating aftertax



 ROC
Total cap. in 2019
New cap. during 2020
Total cap. in 2020
Operating income in
2020
2019 2020

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 Table 4.4: EVA & ROC of some firms in June 2013
Note: Operating income = Net income + aftertax interests
※ some observations based on Table 4.4
1. Operating income does not take into account the cost of capital
2. EVA recognizes that companies need to cover their opportunity
costs before they add value
3. EVA (or ROC) is a better measure of a company's performance than
operating income
4. EVA and ROC are not comparable across firms, but "Excess return"
of Column 6 is.
2. Return On Assets (ROA)
 it measures aftertax operating income as a fraction of the firm's total assets
Total assets = total liabilities + shareholders' equity
 total assets >= total capitalization
% 9 . 8
920 , 41
658 , 3
assets total
income operating aftertax
assets on Return
 

※ ROA based on another measure of total capitalization:
% 7 . 8
2 / ) 779 , 42 920 , 41 (
658 , 3
assets total average
income operating aftertax
assets on Return




Total assets
in 2019
Adding new assets during 2020
Total assets in 2020
Operating income in
2020
2019 2020

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- a caveat:
assets total
income operating aftertax
 ROA
versus
a s s e t t o t a l
i n c o m e n e t

NI
ROA
Total Assets: 96,000
Aftertax operating income = 10,400
Low-debt No-debt High-debt
ROA 10.833% 10.833% 10.833%
NI
ROA
10.292% 10.833% 9.479%
2. Return on Equity (ROE)
 it is the income to shareholders per dollar that they have invested
% 0 . 29
297 , 11
281 , 3
equity
income net
ROE equity on Return
 
 
% 4 . 28
2 / ) 833 , 11 297 , 11 (
281 , 3
equity average
income net
ROE equity on Return



 
Debt usage Low No High
Revenues 76000 76000 76000
- Costs 43000 43000 43000
- Other administrative expenses 15000 15000 15000
- Depreciation and Amortization 2000 2000 2000
Operating Income (EBIT) 16000 16000 16000
- Interests 800 0 2000
Taxable income 15200 16000 14000
- Taxes (35%) 5320 5600 4900
Net Income 9880 10400 9100