12/20/2017

Principles of Finance
with Excel, 2nd edition

Instructor materials

Chapters 17
Capital structure and
the value of the firm

Overview
Capital structure is finance jargon for
how a firm should be financed?
What mixture of debt and equity
should be used by the shareholders of
a firm to finance the firm’s activities?

The Fair City Supermarket

Does Financing Affect the Price?
Mortimer and Joanna are competing to
buy the supermarket.
The supermarket they manage will have
the same sales, cost of goods sold, etc.
Mortimer wants to borrow 50% of the
money needed to purchase the
supermarket
Joanna does not want to borrow, wants
to finance the supermarket by equity.

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The Fair City Supermarket

Does Financing Affect the Price?
Who can afford to make the higher bid
for the supermarket?
Lets look at some possible answers.
If both of them bid $1 million for the
supermarket how would the balance
sheets would look like?
Why would both of them make a
similar bid for the supermarket?

The Fair City Supermarket

Does Financing Affect the Price?
A supermarket is a supermarket is a
supermarket, no matter how it is
financed?
The fact that one finances with debt
and equity whereas the other group
finances only with equity is irrelevant.

The Fair City Supermarket

Does Financing Affect the Price?
Mortimer thinks that he can afford to
bid more for the supermarket
The fact that we’re financing with debt
means that it’s cheaper for us to finance
the supermarket. The interest paid on
debt is an expense for tax purposes,
which means that debt is cheaper than
equity. In addition, because equity is more
risky than debt, equity holders in any case
want a higher return than debt holders.

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The Fair City Supermarket

Does Financing Affect the Price?
 Does the choice of financing affect the total cash
that can be extracted from the firm? If Mortimer,
with its higher proportion of debt financing, can
extract more cash from the supermarket, then it
might be logical for them to be willing to pay more
for the supermarket.
 Should the choice of financing affect the discount
rate the firm uses to evaluate projects? There is
where risk, the magical word in finance, comes into
play. In simple words, is the correct discount rate to
be used for the supermarket by Mortimer different
from that which should be used by Joanna. Does
the choice of a financing mix affect the WACC?
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Simple version
A firm’s method of financing does not
affect its market value.
A firm’s WACC is not affected by the
financing mix between debt and equity

Behind these conclusions:

Assumptions about the corporate tax rate
and the taxes paid by the corporation’s
shareholders and bondholders

Capital Structure When There

Are Corporate Taxes-ABC Corp.
Assumptions: There are corporate
taxes but no personal taxes
Arthur is trying to find out:
Whether to buy ABC Corp
If he buys the company, how to finance
the purchase

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Capital Structure When There

Are Corporate Taxes-ABC Corp.
ABC has an expected annual FCF of
$1,000 per year. This FCF is
anticipated to reoccur, year after year,
at the same level.
Cost of capital=𝑟𝑈 =20%
U stands for unlevered
VU=?

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Capital Structure When There

Are Corporate Taxes-ABC Corp.
Arthur can also get loan
Perpetual debt: There is only annual
payment of interest but no repayment of
principal.
rD=8%
The company borrows $3,000 to finance
the activities.

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Capital Structure When There

Are Corporate Taxes-ABC Corp.
VU=Unlevered value of
ABC=PV(future FCF’s, discounted
@unlevered discount rate)
VL=Levered value of ABC=Unlevered
value of ABC + PV(additional debt
related CFs)
VL=VU+PV (Interest tax shield)

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Capital Structure When There

Are Corporate Taxes-ABC Corp.
The cost of equity (rE(L))
Calculate the cash flows received by the
equity owners.
Annual equity cash flows=FCF-after tax
interest paid by ABC
𝑒𝑞𝑢𝑖𝑡𝑦 𝑐𝑎𝑠ℎ 𝑓𝑙𝑜𝑤𝑡
𝐸 = 𝐸𝑞𝑢𝑖𝑡𝑦 𝑣𝑎𝑙𝑢𝑒 = σ∞
𝑡=1 (1+𝑟𝐸 )𝑡

𝐷
𝑟𝐸 𝐿 = 𝑟𝑈 + [𝑟𝑈 − 𝑟𝐷 ] 𝐸 (1 − 𝑇𝐶 )

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Capital Structure When There

Are Corporate Taxes-ABC Corp.
𝐸 𝐷
𝑊𝐴𝐶𝐶 = 𝑟𝐸 𝐿 + 𝑟𝐷 (1 − 𝑇𝐶 ) 𝐸+𝐷
𝐸+𝐷

𝐹𝐶𝐹𝑡
σ∞
𝑡=1 (1+𝑊𝐴𝐶𝐶)𝑡

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Capital Structure When There

Are Corporate Taxes-ABC Corp.
Conclusion
If only corporate income is taxed,
leverage (borrowing) increases the value
of the firm.
The increase in value, represented by the
present value of the tax shields on the
debt, increases the cost of equity, 𝑟𝐸 and
decreases the WACC.

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Buying a Turfing Machine

Wonderturf Corp. is considering
purchasing a new turfing machine.
The machine costs $100,000
It has a 10 year life
Straight line depreciated to 0 salvage
value.
In each of the 10 years of the
machine’s life, it will produce sales of
$40,000.
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Buying a Turfing Machine

These sales will cost $15,000 to
produce.
NPV?

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Buying a Turfing Machine

The turfing machine’s manufacturer
offers the company a loan of $50,000.
Interest rate on the loan is 8% (this is also
the market interest)
The loan payments in years 1-9 consists only
interest payments
At the end of the 10th year, Wonderturf must
repay the loan principal.
NPV?
Total NPV?
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Where does the positive Loan

NPV come from?
NPV of loan is equal to the PV of tax
shields
VL=VU+PV(tax shields)

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Relevering Potfooler, Inc.

Another Example
Potfooler, Inc. is a well-known Lower
Fantasia company.
Potfooler expects to have an annual
after tax free cash flow of $2 m. at the
end of the years, forever.
Potfooler has 100,000 shares
outstanding and per share price is
$100.

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Relevering Potfooler, Inc.

Another Example
Currently has no debt
An analyst suggested that the
company issue $3,000,000 of
perpetual debt and use the proceeds
to repurchase shares
Intrest rate on debt is 8% and the
payments will be done annually.

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Relevering Potfooler, Inc.

Another Example
Market value of the company?
New market value after the debt
issuance?
Total equity value after share
repurchase?
Price to repurchase shrares?
Number of shares to repurchase?
Cost of equity before share
repurchase (before borrowing)?
22

Relevering Potfooler, Inc.

Another Example
Costof equity after share repurchase?
WACC before share repurchase?
WACC after share repurchase?
Why 𝑟𝐸 (𝐿) > 𝑟𝑈 ?
In addition to business risk now there is
also financial risk.

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Relevering Potfooler, Inc.

Another Example
Why does MV increased when
borrowed?
PV of tax shield
Why WACC decrease after
borrowing?
The company gains riskless cash flow
from tax shields thus average risk of the
total cash flows decrease
What happens if tax rate is 0?

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Considering Personal as well as

Corporate Taxes
 Until now the corporations are taxed
but not the individuals thus
shareholders benefit from having
companies borrow instead of doing
the borrowing themselves.

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Considering Personal as well as

Corporate Taxes
Lets assume
Corporations are subject to a 40%
corporate tax rate, T C
Individuals income derived from shares
(dividends and capital gains on shares-
equity income) is subject to a 10% tax
rate, TE
All ordinary income (individual income
derived from bonds, not include equity
income) is subject to 30% tax rate, T D

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Considering Personal as well as

Corporate Taxes
How to finance purchase of XYZ Corp.
Should the purchase of the company be
financed with debt?
If so who should borrow-the company or
the owner?

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Considering Personal as well as

Corporate Taxes
𝑇𝑜𝑡𝑎𝑙 𝑐𝑎𝑠ℎ 𝑝𝑟𝑜𝑑𝑢𝑐𝑒𝑑 𝑏𝑦 𝑓𝑖𝑟𝑚 =
𝐹𝐶𝐹 − 𝑟𝐷 ∗ 𝐷𝑒𝑏𝑡 ∗ 1 − 𝑇𝐶 ∗
1 − 𝑇𝐸 + 𝑟𝐷 ∗ 𝐷𝑒𝑏𝑡 ∗ 1 − 𝑇𝐷
= 𝐹𝐶𝐹 ∗ 1 − 𝑇𝐸 + 𝑟𝐷 ∗ 𝐷𝑒𝑏𝑡 ∗
[ 1 − 𝑇𝐷 − 1 − 𝑇𝐸 ∗ (1 − 𝑇𝐶 )]

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Modigliani-Miller propositions
Adds
Replacing Equity with Debt Value if
Subtracts

1  TD   1  TC  * 1  TE  0

where
TD  tax rate individuals pay on interest
TE  tax rate individuals pay on equity payouts
TC  corporate tax rate

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Valuing XYZ Corp. The Effect of Leverage

when there are Corporate and Personal
Taxes
VU=Unlevered value of
XYZ=PV(future FCF’s, discounted
@unlevered discount rate)
VL=Levered value of XYZ=Unlevered
value of XYZ + PV(additional debt
related CFs)
VL=VU+PV (Interest tax shield)

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Valuing XYZ Corp.

𝑃𝑉 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑡𝑎𝑥 𝑠ℎ𝑖𝑒𝑙𝑑𝑠 =
1−𝑇𝐷 − 1−𝑇𝐶 ∗ 1−𝑇𝐸 ∗𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡𝑡
σ∞
𝑡=1 (1+ 1−𝑇𝐷 ∗𝑟𝐷 )𝑡
1−𝑇𝐷 − 1−𝑇𝐶 ∗ 1−𝑇𝐸 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡
= ∗ 𝑟
(1−𝑇𝐷 ) 𝐷
=T*D

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Cost of capital and WACC

Annual after corporate tax equity cash
flow=[FCF-after tax interest paid by
XYZ]
𝑒𝑞𝑢𝑖𝑡𝑦 𝑐𝑎𝑠ℎ 𝑓𝑙𝑜𝑤𝑡
𝐸𝑞𝑢𝑖𝑡𝑦 𝑉𝑎𝑙𝑢𝑒 = σ∞
𝑡=1 (1+𝑟𝐸 )𝑡
𝑟𝐸 = 𝑟𝑈 + [𝑟𝑈 ∗ 1 − 𝑇 − 𝑟𝐷 ∗

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Buying a Turfing Machine

The company is in Upper Fantasia
Corporate income tax rate (TC) =40%
Personal equity income tax rate (TE)
=10%
Personal income from all other
sources tax rate (TD) =30%

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Buying a Turfing Machine

Sonderturf Corp. is considering
purchasing a new turfing machine.
The machine costs $100,000
It has a 10 year life
Straight line depreciated to 0 salvage
value.
In each of the 10 years of the
machine’s life, it will produce sales of
$40,000.
34

Buying a Turfing Machine

These sales will cost $15,000 to
produce.
The risk adjusted discount rate for
FCF’s=15%
NPV?

35

Buying a Sturfing Machine

The turfing machine’s manufacturer
offers the company a loan of $50,000.
Interest rate on the loan is 8% (this is also
the market interest)
The loan payments in years 1-9 consists only
interest payments
At the end of the 10th year, Sonderturf must
repay the loan principal.
NPV?
Total NPV?
36

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Buying a Sturfing Machine

Adds
Replacing Equity with Debt Value if
Subtracts

1  TD   1  TC  * 1  TE  0

where
TD  tax rateindividuals pay oninterest
TE  tax rateindividuals pay on equity payouts
TC  corporate tax rate
37

Relevering Smotfooler, Inc.

Another Example
Smotfooler, Inc. is a well-known Upper
Fantasia company.
Smotfooler expects to have an annual
after tax free cash flow of $2 m. at the
end of the years, forever.
Smotfooler has 100,000 shares
outstanding and per share price is
$100.

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Relevering Smotfooler, Inc.

Another Example
Currently has no debt
An analyst suggested that the
company issue $3,000,000 of
perpetual debt and use the proceeds
to repurchase shares
Interest rate on debt is 8% and the
payments will be done annually.
Tax rates are TC=40%, TD=30%,
TE=10%,
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Relevering Smotfooler, Inc.

Another Example
Market value of the company?
New market value after the debt
issuance?
Total equity value after share
repurchase?
Price to repurchase shrares?
Number of shares to repurchase?
Cost of equity before share
repurchase (before borrowing)?
40

Relevering Smotfooler, Inc.

Another Example
Costof equity after share repurchase?
WACC before share repurchase?
WACC after share repurchase?
Why 𝑟𝐸 (𝐿) > 𝑟𝑈 ?
In addition to business risk now there is
also financial risk.

41

Relevering Smotfooler, Inc.

Another Example
Why does MV increased when
borrowed?
PV of tax shield
Why WACC decrease after
borrowing?
The company gains riskless cash flow
from tax shields thus average risk of the
toal cash flows decrease

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