QDai for FEUNL Finance I November 21. QDai for FEUNL Topics covered  Last class: MM without taxes  This class: MM with corporate taxes.

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Presentation transcript:

QDai for FEUNL 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 Debt-to-equity Ratio Cost of capital: r (%) r0r0 rBrB rBrB S B

QDai for FEUNL The MM Proposition I (Corp. Taxes)  Shareholders receiveBondholders 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 Debt-to-equity ratio (B/S) Cost of capital: r (%) r0r0 rBrB

QDai for FEUNL Total Cash Flow to Investors Under Each Capital Structure with Corp. Taxes All-Equity RecessionExpectedExpansion EBIT$1,000$2,000$3,000 Interest EBT Taxes (Tc = 35%) Total Cash Flow to S/H Levered RecessionExpectedExpansion EBIT$1,000$2,000$3,000 Interest 8% ) EBT Taxes (Tc = 35%) Total Cash Flow (to both S/H & B/H): EBIT(1-Tc)+T C r B B

QDai for FEUNL 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