capital structure ii corporate income taxes. review question describe the two basic capital...
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![Page 1: Capital Structure II Corporate income taxes. Review question Describe the two basic capital budgeting decisions](https://reader036.vdocuments.mx/reader036/viewer/2022062407/56649d395503460f94a12847/html5/thumbnails/1.jpg)
Capital Structure II
Corporate income taxes
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Review question
Describe the two basic capital budgeting decisions.
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Answer
Project acceptance: each project is independent of others. Each is accepted or rejected.
Choice between mutually exclusive projects. Of two or more projects, only one can be undertaken.
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MM II without taxes
Facts and derivation. Fact 1: Leverage does not change
market value Fact 2: All cash flows are accounted
for.
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BSS LU
BrSrSr BLSU 0
MM I
Cash
BrSrBSr BLSL )(0
BrBSrSr BLLS )(0
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BrBSrSr BLLS )(0
BrrSrSr BLLS )( 00
LBS S
Brrrr )( 00
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MM Proposition II no tax
Debt-to-equityratio (B/S)
Cost of capital: r(%)
.r0
rS
rWACC
rB
LBS S
Brrrr )( 00
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Weighted average cost of capital
The cost to the firm of undertaking a project.
Here independent of leverage … because leverage doesn’t matter.
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Now with taxes.
No threat of bankruptcy. Corporate taxes, not personal. Government gets a piece of the pie. A smaller piece if the firm has debt.
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MM I with taxes
VU = market value of the unlevered firm VL = market value of the levered firm B = market value of bonds TC = corporate tax rate VL = VU + TC B
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Why?
Why isn’t the bond rate in the formula? The bond is a perpetuity. Market rB is the right discount rate for
the perpetuity.
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Short derivation
Each year the tax shield is rBTCB
Value of tax shield is rBTCB/rB = TCB
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MM II (with taxes)
Corporate taxes, not personal rB = interest rate rS = return on equity r0 = return on unlevered equity B = value of debt SL = value of levered equity Previously, without taxes
rS = r0 + (B/SL)(r0 - rB)
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Effect of tax shield
Increase of equity risk is partly offset by the tax shield
rS = r0 + (1-TC)(r0 - rB)(B/SL) Leverage raises the required return less
because of the tax shield.
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MM II and WACC
Debt-to-equityratio (B/S)
Cost of capital: r
(%)
.r0
rS
rB.. rWACC
.
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WACC not equal to r0. Why?
r0 is the return on unlevered equity.
WACC is for risk like that of the physical asset of the firm.
Adding debt reduces risk of the asset of the firm.
Adding debt reduces WACC. The levered firm is in a lower risk
category.
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WACC declines with leverage.
Why? Because the project is producing bigger
interest tax shields, and the tax shields are a relatively safe
asset.
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rS increases with leverage. Why?
Leverage raises risk … and is only partly offset by the tax
shield.
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A little derivation
Again. Market value equation. Cash flow equation. The latter is a version of WACC.
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BTSBS CUL
BrTSrBrSr BCUBLS 0
MM I
Cash
BrBrTSrSr BBCULS 0
BrBrT
BTBSrSr
BBC
CLLS
)(0
Rewrite cash
Sub in MM I
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BrBrT
BTBSrSr
BBC
CLLS
)(0
)1(
)1(00
CB
CLLS
TBr
TBrSrSr
))(1( 00 BCL
S rrTS
Brr
Copying
Combineterms
Finally
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Review question
Does a good project have IRR greater than the hurdle rate, or less?
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Answer
IRR is the discount rate that makes NPV(IRR) = 0.
The hurdle rate is the market rate for the risk-class.
Investing means cash flows are first negative, then positive.
Financing (in this context) means cash flows are first positive, then negative.
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More answer
Other sign patterns, IRR is not useful. Investing, a good project has IRR >
hurdle rate. Financing, a good project has hurdle
rate > IRR.
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