3.2: Capital Structure & Valuation with Taxes

Question 1

Why is there an incentive to use debt?

Answer 1

Taxes are paid on profits after interest expenses are deducted, so more debt raises the interest expenses, lowers the profit and the taxes paid

Question 2

What is the interest tax shield?

Answer 2

The gain to investors from the tax deductibility go interest payments.

Interest tax shield = Corporate tax rate * interest payments

Question 3

What is the MM proposition I with taxes?

Answer 3

The total value of the levered firm exceeds the value of the firm without leverage due to the present value of the tax savings from debt

Question 4

What are steps of market value balance sheets we can draw up in the case of a leveraged recapitalisation?

Answer 4

• Initial
• Recap announced. future interest tax shield is anticipated, raising the value of assets
• Debt issuance
• Share repurchase

Question 5

What is the WACC method?

Answer 5

Discounting the unlevered free cash flows using the weighted-average cost of capital. r(wacc) is calculated using the effective after-tax interest rate as the cost of debt, so the tax benefit of debt is incorporated implicitly

Question 6

What is the Adjusted present value method (APV)?

Answer 6

First value a project’s free cash flows without leverage by discounting them using the unlevered cost of capital, then separately estimate and add the present value of the interest tax shields from debt.

Question 7

What are the assumptions for the WACC method to be valid?

Answer 7

• The project has average risk (compared to firm assets).
• The firm’s debt-equity ratio is constant (at each point in time)
• Corporate taxes are the only imperfection.

Question 8

What are the three steps of the WACC method?

Answer 8

1. Determine the free cash flow of the investment.
2. Compute the weighted average cost of capital using the first equation.
3. Compute the value of the investment, including the tax benefit of leverage, by discounting the free cash flow of the investment using WACC.

Question 9

What is a target leverage ratio?

Answer 9

When a firm adjusts its debt proportionally to a project’s value or cash flows

Question 10

What is a firm’s debt capacity?

Answer 10

The amount of debt that is required to maintain their target debt-to-value ratio

Question 11

What discount rate should we use on the interest tax shield in the APV method?

Answer 11

The unlevered cost of capital. When a firm maintains a target leverage ratio, its future interest tax shield have similar risk to the project’s cash flows

Question 12

What are the steps of the APV method?

Answer 12

1. Determine the investment’s value without leverage, VU, by discounting its free cash flows at the unlevered cost of capital, rU.
2. Determine the present value of the interest tax shield: a) Determine the expected interest tax shield
   b) Discount the interest tax shield. If a constant debt-equity ratio is maintained, using rU is appropriate.
3. Add the unlevered value, VU, to the present value of the interest tax shield to determine the value of the investment with leverage, VL.

Question 13

Which method is the simplest to use for alternative leverage policies?

Answer 13

The APV method