Chapter 15 - Debt and taxes Flashcards
Recall how capital structure affects the value of the firm
It doesn as long as there are perfect capital markets.
This is because the total value of the firm is determiend by the assets that generate cash flows. We have to consider all cash flow distribitom channels, not just assume the perspective of an equity holder/investor.
Name a reason(s) why capital structure is actually important to the firm
empirical evidence shows that firms spend huge sums of money on it. Investment banking fees etc.
Why are firms havign different capital structures if it doesnt affect the value of the firm?
The key is that Modigliani and Millers ideas only apply to perfect capital markets.
in this chapter, we focus on one imperfection that cause friction in the perfect capital market theory: taxes
How does itnerest payment relate to taxes?
Corporations pay taxes on profits AFTER interest payments are deducted. Therefore, interest payments reduce the amount of taxes a corporation must pay.
Since corporations reduce their tax payments in the presence of interest payments, what does this do?
It creates an incentive to use debt.
What can we say in general about using leverage in terms of what happens to the income
Altough the net income/profits that is left for equity holders may be less when using debt/leverage than without leverage, the total amount of money/cash available to ALL investors is higher with leverage.
when we add the debt payment and the equity payment together, we get this result. And this result is an outcome of the fact that using leverage decrease TAXES. Since taxes can be regarded as cash flow that is not going to investors, we naturally want to reduce this part. This is what happens when using leverage. By re-allocating cash flow from all-equity to leveraged equity, we will increase the proportion of the cash flows that remain inside of the “hands” of the various investors.
Does leverage carry an effect on the value of the firm?
Yes, in the presence of taxes.
When taxes are present, and as long as interest is tax deductible, the firm can reduce the amount of cash that goes to taxes.
We increase debt, and by doing so, we increase the interest tax shield, which reduce the amount of money that does not go to investors.
The key to understanding this effect, is to consider the underlying assets of the firm. These assets generate cash flow, and will be given a market value thereafter. However, an investor will consider the value of these assets as relative to what he can get. by reducing the amount of taxes, we keep more of the cash flow produced by the assets, which means that these cash flows are available to the investors. It is all about keeping money to the investors.
What can we say from this image?
The effect is leverage is displayed. Do not be fooled by the decreased net income. This only tells the equity-part of the story.
We want to look at the fact that the firm generate the same amount of cash flows regardless of capital structure. The assets remain the same, and still generate the same cash flows.
We can see that using leverage results in paying 140 less in taxes. This means, 140 less is payed OUT of the firm. This is the key result here.
Using leverage will decrease taxes the firm has to pay, which keeps more of the cash flows inside of the hands of the various investors.
Let us say we have $400 million in interest payments. What is this sum called?
We say that this sum is shielded from taxes.
Say we have $400 million in interest payment. What is the interest tax shield?
The 400 is shielded from taxes, and we can calculate the tax shield like this:
interest tax shield = corporateTaxRate x ShieldedAmount = 0.35 x 400 = 140
We basically get this equation from the regular tax equation:
(income - interest) x (1 - taxRate) =income - income x taxRate - interest + interest x taxRate
= income (1 - taxRate) - interest (1- taxRate)
= income (1 - taxRate) - interest + interest x taxRate
so, our profits is aided by the interest tax shield. At the same time, we still have to deduct interest, but as we know, this is value that still go to our investors.
1) A firms value is equal to the total amount of cash delivered to its ivnestors. Taxes reduce this amount. Therefore, if we can find a way to reduce taxes, we will increase the value of a firm.
Since using leverage is a way to utilize the interest tax shield to reduce the amount of the cash flows that are strictly removed from the business, using leverage can increase the value of the firm.
2) interest tax shield is the amount of cash flows that we increase the firms value with by using the leverage. It is calculated as interestPayments x taxRate
is the interest tax shield a one-time thing?
no, using leverage typically yield a shield for a number of years, specifically equal to the nubmer of years the firm pays interest.
Because of this, we consider the value of the interest tax shield to be equal to the present value of the stream of future interest tax shields the firm will receive.
Give the yearly relationship between cash flows to investors with leverage and wihtout
Cash flows to investors with leverage must be equal (each year) to the cash flow given to investors without leverage + the interest tax shield
what are we really doing to reduce taxes?
We have to reduce the amount of “pretax income”.
How do we change MM1 proposition to fit taxes?
Value of cash flows Leveraged = Value of cash flows unlevered + PV(interest tax shields)
In other words:
the total value of the levered firm exceeds the total value of the unlevered firm by exactly the present value of the interest tax shield.
ELaborate on issuing a perpetual consol bond
This is a kind of debt that pays interest forever (same dollar amount) but never repay the principal.
Suppose a firm borrows debt D, and keeps it infinite by always refinancing so that D is kept.
What is the value of the interest tax shield?
We know that the interest payment in period will be D x rate. Therefore, the interest tax shield per period is: taxRate x D x interestRate
then we treat this as a perpetuity, which allows us to use the very simple formula of value/rate to get the perpetual present value:
(raxRate x D x interestRate) / interestRate = taxRate x D
This result means that for every dollar we increase the debt D with, the present value of the interest tax shield, and therefore also the entire firm, increase by the taxRate.
NB: we must not forget the assumption we make in this case. We assume that the firm has constant debt infinitely so that we can use teh perpetutiy formula.
elaborate on effective borrowing rate
Using leverage in combination with an interest tax shield will actually reduce the after-tax cost of borrowing.
For instnace, if we borrow 100 000 at 10% interest, we’d expect to pay 10 000 each period. However, since we also have an interest tax shield included, we must account for it:
10 000 x taxRate = 10 000 x 0.21 = 2100. Therefore, the amount we actually have to pay to borrow, is 10 000 - 2 100 = 7900.
The effective borrow rate / cost of debt is therefore:
7900 / 10000 = 7.9% and not 10%.
In other words: THe effective after tax borrowing rate is: interestRate x (1 - taxRate)
elaborate on WACC
Now we can finally add the tax component. We know that interest tax shield reduce the after tax cost of borrowing by a factor of (1-tax), so we add it to the formula.
What can we say about the pretax WACC in regards to WACC?
Pretax will be larger because it doesnt account for the tax shield.
Instead of maintaining constant level of debt, what is typically done by many firms?
Go for a specific target debt/equity ratio. The benefit of the debt - equity ratio is that it allows the debt to grow with the growth of the firm.
what is a recapitalization?
A recapitalizaiton is whne a firm makes a significant change in its capital structure. Leveraged is one way to do this.
In the case of perpetual constant debt, what can we say about the interest tax shield?
The interest tax shield is in these specific cases independent of the interest.
The interest tax shield each period is given by:
total debt x intrest rate x taxRate
Since we will be “payed” this value every period, we can treat it with the annuity formula:
(debt x interest rate x taxRate) / interest rate
= debt x taxRate
So, if a firm takes on 100 million in debt on a constant basis, the interest tax shield is 100 x taxRate
elaborate on recapitalization using leverage. For instance going from all equity to leveraged
When we are all equity and start adding leverage, we know that the total value of the firm will increase by the interest tax shield added.
Since tax shield is going to the shareholders, this is equity.
Therefore, immediately after it is known that the firm will take on debt to recapitalize, the public will respond by shooting the price up (without a single purchase being sold; assuming intelligent investors).
We calculate the new share price by considering the new equity market value, and dividng by the shares outstanding.
The market value of equity is calculated by considering the market value of equity before hte news (shares outstanding x old share price) and adding the interest tax shield of debt x taxRate (perpetual debt).
The new share price represent less the old share price, together with the old/current shares outstanding, a proportion of equity equal to the tax shield.
now we buy shares, and equity of the firm is reduced by the debt amount.
so, equity market value is reduced, but total value of firm is increased. Also, original shareholders are better of (tax shield).