Chapter 15 - debt and taxes

Question 1

recall the outcome of perfect capital markets

Answer 1

the law of one prices makes it so that no finanacial trnasaction can create or destroy value

Question 2

what happens when increasing debt

Answer 2

The levered equity becomes more risky. as a consequyence, the equity cost of capital will increase.

Recall that the WACC remain the same in perfect capital markets.

Question 3

Why do we need this chapter?

Answer 3

The previous results only apply in perfect capital markets. Capital markets are not perfecrt

Question 4

Recall the definition of perfect cpaital markets

Answer 4

3 asumptions:

1) no transaciton costs, no taxes, no issuance costs

2) Everyone can trade freely at competitive market prices determined by the law of one price and the present value of the underlying assets of the firm.

3) Financing decisions made by firms will not alter the underlying assets that ultimately produce cash flows

Question 5

What is taxes in this context+

Answer 5

A market imperfection that make the assumptions of perfect cpiatla markets WRONG

Question 6

elaborate on the reason why taxes are interesting

Answer 6

corporations pay taxes on their earnings. In other words, after the interest have been deducted. This means that interest limit the taxes we must pay.

Question 7

Make sense of the core importance regarding taxes and interest and how they affect corporations

Answer 7

The thing is that taxes take money away from all investors. if we can increase debt to limit taxes, then we are essentially re-allocating cash flow going out of the firm, to going to some kind of investor.
In many cases, the earnings left to equity holders will likely be reduced with more debt, because the interest payment means less taxable income. However, the total value of the firm remains in a better place.

It is this total value of the firm that is important to us.

Question 8

What is an important outcome of trying to maximize the cash flows going to all investors, rather than only looking at equity holders?

Answer 8

The firm will maximize the amount of capital it can raise initially. This can be critical for operations.

Question 9

What do we call the gain to invstors that come as a result of adding more debt and itnerest?

Answer 9

interest tax shield.

interest tax shield = taxRate x interestPayments

How do we derive it?

cash flow = net income x (1-tax)

= (income - interest) x (1-tax)

= income - tax x income - itnerest + interest x tax

= income (1 - tax) - interest + interest x tax

Now we know that the income after tax and the interest goes to investors. It is only the interest x tax that goes to non-investors.

Question 10

how do we value the benefit of hte interest tax shield?

Answer 10

interest tax shield is an annual benefit. Therefore, it is a repeating thing. Therefore, we must find it s present value to evaluate what its real benefit is.

Question 11

What is the equation that shows “cash flow to investors using leverage”?

Answer 11

Question 12

What is the MM1 proposition in presence of taxes?

Answer 12

Question 13

what do we typically need to be able to solve tasks related to how big of a benefit the tax shield is?

Answer 13

We need the debt to be on the shape of an annuity or perpetutyiy

Question 14

elaborate on treating the interest tax shield as a perpetuity

Answer 14

Suppose a firm borrow debt D indefinitely.

if the tax rate it t, and the debt is riskless with rate rf, then the shield is t x rf x D.
If perpetuity, we divide on the rate. This basically gives us PV = t x D

Question 15

What is the relationship between WACC and leverage?

Answer 15

More leverage implies lower WACC

Question 16

What is recapitalizaiton?

Answer 16

typically a recapitalizaiton is defined as a significant change in the capital structure

Question 17

Why were leveraged recaps popular in the 1980s?

Answer 17

People found out that they could reduce their taxes by doign so

Question 18

A firm has 20 million shares outstanding, traidng at $15 per share.
tax rate of 21%.

It plans to borrow $100 million to buy back shares (recap).

elaborate on the dynamics in play here

Answer 18

First of all, before the deicison is made, the value of the equity is 15 x 20 million = 300 million.

If they borrow 100 million to buy back shares, the capital structure change, and we get the interest tax shield as a benefit. We can compute thus shield: taxRate x Debt
Assuming permanent constant debt, we get 21% x 100 million = 21 million.

We know that the value of the levered firm is equal to the value of the unlevered firm + the present value of the interest tax shield. 21 million is the present value of the interest tax shield.
we need to find the unlevered value of hte firm.
Turns out, we already have: 300 million.
So, the levered value of the firm is 321 million.

The real question we are interested in is, does the recap benefit the sahreholders?

So, the value of the firm increase from 300 to 321, but 100 of it is debt. Therefore, the market value of equity drops from 300 to 221. Interesting, the equity does not drop by the full debt amount. In fact ,the differnece is the 21 million, which equals the interest tax shield.

Right befoire the purchase of shares, the firm has 321 million in equity. This is because it was orignally 300, and the addition of 21 million shield increase hte value.
The new share price is 16.05. this is the price that the firm must pay for the shares, because shareholders are not willing to trade them away at the previous price.

After buying shares worth 100 million, the remaingin shares outstanding multiplied by the new share price (16.05) equals the new market value of equity which is 221 million.

The entire point here is that the market value of equity is reduced, but the shareholder value is increased. Why? Because each share increased in value by 1.05 dollars. The original owners of the shares benefit from this change. Some must sell, others keep, the gain is the same.

Question 19

What do we need to remember with the market value balance sheet when taxes are present?

Answer 19

We must include the interest tax shield as an asset

Question 20

how can sahreholders benefit from a recap when the market value of equity is reduced?

Answer 20

they benefit because while the market value of equity is reduced, the amount of shares is reduced as well. The interest tax shield represent an amount that the sahreholders can gain by sending a greater portion of the firms cash flows to debt holders rather than all equity.

Question 21

elaborate on personal taxes, and how they relate to corporate decisions

Answer 21

WE know that hte value of a firm is equal to the amount of moeny that the firm can raise by issuing securites, either as debt or equity or whatever.
But the amount of money we as iunvestors are willing to pay for these securities, depend on how much we will get from it.

As investors, we want to maximize the after-tax income.

Interest income has a tendency to be taxed harder than equity income (probably due to the less risky nature of it).
However, itnerest income is not double taxed like equity returns are.

The cash investors receive from equity: (1 - corpTax) x (1 - equityTax)
The cash investors receive from debt/interest: (1 - interestTax)

Unless these two values are identical, there will be a tax disadvantage of one of them.

Question 22

How is tax advantage/disadavtange coimputed?

Answer 22