Finance I

November 21 QDai for FEUNL

Topics covered

  Last class: MM without taxes This class: MM with corporate taxes QDai for FEUNL

The MM Propositions I & II (No Taxes)  Proposition I  Firm value is not affected by leverage  Proposition II  Leverage increases the risk and return to stockholders QDai for FEUNL

MM Proposition II with No Corporate Taxes

r

0

r B

QDai for FEUNL Debt-to-equity Ratio

B S r B

The MM Proposition I (Corp. Taxes)

 Shareholders receive Bondholders receive  The total cashflow to all the stakeholders is  The present value of the stream of cashflow is QDai for FEUNL

The MM Proposition II (Corp. Taxes)

Start with M&M Proposition I with taxes: The balancen sheet of a levered firm can be written as QDai for FEUNL

The MM Proposition II (Corp. Taxes) The cash flows from each side of the balance sheet must equal QDai for FEUNL

The MM Propositions I & II (with Taxes)  Proposition I (with Corporate Taxes)  Firm value increases with leverage  Proposition II (with Corporate Taxes)  Some of the increase in equity risk and return is offset by interest tax shield QDai for FEUNL

The Effect of Financial Leverage on the Cost of Debt and Equity Capital with Corporate Taxes Cost of capital:

r (%) r

0

r B

Debt-to-equity ratio (

B

/

S

) QDai for FEUNL

Total Cash Flow to Investors Under Each Capital Structure with Corp. Taxes All-Equity Recession $1,000 Expected $2,000 EBIT Interest EBT Taxes (

T

c = 35%) Total Cash Flow to S/H EBIT Interest ($800 @ 8% ) EBT Taxes (Tc = 35%) Total Cash Flow (to both S/H & B/H):

EBIT(1-Tc)+T C r B B

Levered Recession $1,000 Expected $2,000 QDai for FEUNL Expansion $3,000 Expansion $3,000

Tax effect of debt

 In a world without taxes  When there are corporate taxes  With taxes, the sum of the debt plus the equity of the levered firm is QDai for FEUNL

Total Cash Flow to Investors

All-equity firm Levered firm QDai for FEUNL

One question to ask

Is it so that firms should then choose 100% debt in order to maximize the tax shield for the firm?

In the next class, we will introduce a limit to debt: financial distress QDai for FEUNL