Capital Structure: Debt and Taxes (Week 8) Flashcards
In a less than perfect world, why does capital structure matter?
Because it affects a firm’s tax bill
How do interest payments impact tax?
Interest payments are considered a business expense, and are tax exempt for the firm.
What is the “size of the pie”? (MM)
Value of before-tax cash flows. MM say: the size of the pie is unaffected by capital structure.
How does taxation affect the “size of the pie”?
The government gets a slice too. The firm’s choice of capital structure affects the size of that slice.
How can a firm reduce the size of the governments slice?
Interest payments are tax deductible. The value of the government’s slice can be reduced by using debt rather than equity.
How do you value the interest tax shield?
When a firm uses debt, the interest tax shield provides a corporate tax benefit each year.
What is the Modigliani Miller Proposition I with Taxes?
Modigliani-Miller proposition I with Taxes. 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.
VL = VU + PV(Interest Tax Shield)
Three equations for cash flow
- Cash flow = unlevered cash flow + tax shield
- Cash flow = Net income + Interest
- Cash flow = EBIT - taxes
What is the value of a levered firm?
The present value of its expected total cash flows
V = PV(CF)
V = PV(UCF) + PV(TS)
Can tax shields fluctuate?
Yes
- Risky debt - you don’t get tax shields if you default
- Changing interest payments: if debt keeps changing in the future, interest payments will fluctuate, and so will interest tax shield.
How do you discount the tax shield for any financial policy that implies a predetermined interest payment schedule?
predetermined = we know with certainty the interest we will need to pay
We use the cost of debt to discount the tax shield
kTS = kd
The only risk associated with tax shield is default risk
kd adjusts for default risk
What is a tax shield?
A tax shield is an allowable deduction from taxable income that results in a reduction of taxes owed. Common expenses that are deductible include depreciation and interest expenses.
What is the (semi-strong) efficient market hypothesis?
Stock price must change before the actual debt issue, at the moment the firm announces it will repurchase shares.
If not, you can make money for nothing. Buy one share today, hold it until the debt issue/share repurchase is completed, then sell at a higher price.
What is WACC?
Weighted average cost of capital (WACC)
Represents a firm’s average cost of capital from all sources (incl. common stock, preferred stock, bonds, and other forms of debt).
It is a common way to determine required rate of return as it expresses the return that both bondholders and shareholders demand in order to provide the company with capital.
When is a firm’s WACC likely to be higher?
If the stock is volatile or if its debt is seen as risky because investors will demand greater returns.
