Finance Week 11 Flashcards
What are MM really arguing?
Model implies D:E random and different- know that taxes do exist and markets not perfect- so say capital structure must affect a firm’s value in the real world
What is the interest tax shield?
Companies have to pay taxes on earnings but interest payments deductible. Interest tax shield is savings result from tax deducibility of interest payments, interest tax shield in year t: Tc * interest in year t
What happens if assume company renews debt at end of year forever?
Future tax savings are perpetuity and PV of all interest tax shield is: Tc * D
How does market value of company differ in idealized world with taxes/ without?
With taxes, value doesn’t depend on capital structure so value of firm with debt (levered) equals value of firm without (un-levered): V levered = V un-levered. In a world with taxes, MV does depend on capital structure as interest expenses deductible and reduce firm’s expense. V (levered) = V (un-levered) + PV (Tax shield)
What is different about capital structure in world with taxes?
Borrowing increases risk for shareholders and return on equity. So add corporate tax rate to all calc- even return on assets.
How does value of firm, SE, return on equity, return on assets and WACC change in world with taxes?
Value of firm increases- benefitting from tax shield, Value of SE increases, higher return on equity, WACC is lower.
Why is it beneficial for firms with high debt?
Max tax savings and shareholders value
What is not beneficial about high debt?
More likely have distress and default. Distress has costs: Bankruptcy costs- legal costs of taking firm through BCY, Debt overhang costs- FM threatened with default and may not invest in project with +ve but small NPV as only pay D and E holders.
What is the tradeoff theory?
Optimal amount of D reached when adding more D leads to more benefits from tax shield than loss to stress.
If given a question with a beta from other firms and includes taxes, what should you make sure you do?
Lever up firm beta to account for taxes
What are long term financial decisions?
Decisions about long-lived assets and liabilities (capital budgeting + structure) (e.g. retaining earnings or expand business)
What are short term financial decisions?
Decisions about short-lived assets and liabilities e.g. firms short term assets- stocking up inventory- determined by firm’s cumulative capital requirements and firms long term decisions
What is cumulative capital requirement?
Sum of all investments a business needs- increasing for growing firms and fluctuates- working capital are CA and CL, CA 1/4 firms assets
what are 4 types of CA?
Cash, AR, Inventory, short term securities
