1. Solvay Business School – Université Libre de Bruxelles 11/06/2015Vietnam 20041 Corporate Finance Choosing a Capital Structure Prof. André Farber Solvay Business School Université Libre de Bruxelles

2. Solvay Business School – Université Libre de Bruxelles 11/06/2015Vietnam 20042 Review: MM 58 Debt policy doesn’t matter in perfect capital market MM I: market value of company independent of capital structure V = E + D MM II: WACC independent of capital structure Underlying assumptions: No taxes! Symetric information

3. Solvay Business School – Université Libre de Bruxelles 11/06/2015Vietnam 20043 Corporate Tax Shield Interest are tax deductible => tax shield Tax shield = Interest payment × Corporate Tax Rate = (r D × D) × T C r D : cost of new debt D : market value of debt Value of levered firm = Value if all-equity-financed + PV(Tax Shield) PV(Tax Shield) - Assume permanent borrowing V L =V U + T C D

4. Solvay Business School – Université Libre de Bruxelles 11/06/2015Vietnam 20044 Example A B Balance Sheet Total Assets 1,000 1,000 Book Equity 1,000 500 Debt (8%) 0 500 Income Statement EBIT 240 240 Interest 0 40 Taxable Income 240 200 Taxes (40%) 96 80 Net Income144 120 Dividend 144 120 Interest 0 40 Total 144 160 Assume r A = 10% (1) Value of all-equity-firm: V U = 144 / 0.10 = 1,440 (2) PV(Tax Shield): Tax Shield = 40 x 0.40 = 16 PV(TaxShield) = 16/0.08 = 200 (3) Value of levered company: V L = 1,440 + 200 = 1,640 (5) Market value of equity: E L = V L - D = 1,640 - 500 = 1,140

5. Solvay Business School – Université Libre de Bruxelles 11/06/2015Vietnam 20045 What about cost of equity? 1) Cost of equity increases with leverage: 2) Beta of equity increases Proof: But V U = EBIT(1-T C )/r A and E = V U + T C D – D Replace and solve In example: r E = 10% +(10%-8%)(1-0.4)(500/1,140) = 10.53% or r E = DIV/E = 120/1,140 = 10.53%

6. Solvay Business School – Université Libre de Bruxelles 11/06/2015Vietnam 20046 What about the weighted average cost of capital? Weighted average cost of capital decreases with leverage Weighted average cost of capital: discount rate used to calculate themarket value of firm by discounting net operating profit less adjusted taxes (NOPLAT) NOPLAT = Net Income + Interest + Tax Shield = (EBIT-r D D)(1-T C ) + r D D +T C r D D = Net Income for all-equity-firm = EBIT(1-T C ) VL = NOPLAT / WACC As: In example: NOPLAT = 144 V L = 1,640 WACC = 10.53% x 0.69 + 8% x 0.60 x 0.31 = 8.78%

7. Solvay Business School – Université Libre de Bruxelles 11/06/2015Vietnam 20047 Debt not permanent 0123456 EBITDA340 Dep100 EBIT240 Interest4032241680 Taxes808386909396 Earnings120125130134139144 CFop220225230234239277 CFinv-100 DIV-20-25-30-34-39-144 ∆Debt-100 Book eq.5006007008009001,000 Debt50040030020010000

8. Solvay Business School – Université Libre de Bruxelles 11/06/2015Vietnam 20048 Valuation of company 1. Value of unlevered company Free Cash Flow unlevered = 144 V U = FCF U / r A = 144 / 0.10 = 1,440 2. PV(Taxshield) 3. Value of levered company V = 1,440 + 40 = 1,480 4. Value of equity E = 1,480 - 500 = 980

9. Solvay Business School – Université Libre de Bruxelles 11/06/2015Vietnam 20049 Corporate and Personal Taxes Suppose operating income = 1 If paid out astInterestEquity income Corporate tax0T C Income after corporate tax11 - T C Personal taxT P T PE (1-T C ) Income after all taxes1- T P (1-T PE )(1-T C )

10. Solvay Business School – Université Libre de Bruxelles 11/06/2015Vietnam 200410 PV(TaxShield) with corporate and personal taxes Tax advantage of debt is positive if: 1-T P >(1-T C )(1-T PE ) Note: if TP = T PE, then PV(TaxShield) = T C D

11. Solvay Business School – Université Libre de Bruxelles 11/06/2015Vietnam 200411 Proof of PV(TaxShield) formula After taxes income for Stockholders Debtholders Total This can be written as: Market values VUVU D

12. Solvay Business School – Université Libre de Bruxelles 11/06/2015Vietnam 200412 Still a puzzle…. If PV(Tax Shield) >0, why not 100% debt? Two counterbalancing forces: –cost of financial distress As debt increases, probability of financial problem increases – agency costs Conflicts of interest between shareholders and debtholders

13. Solvay Business School – Université Libre de Bruxelles 11/06/2015Vietnam 200413 Trade-off theory Market value Debt ratio Value of all-equity firm PV(Tax Shield) PV(Costs of financial distress)