Lecture 3 - Capital structure basic concepts II

Question 1

Impact of corporate taxes

Answer 1

Companies can deduct interest payments for tax purposes as it is an expense
Corporate leverage lowers tax payments

Question 2

MM Proposition I with tax

Answer 2

Vl = Vu + present value of tax shield
= Vu + tcB (With perpetual debt)

Corporations can deduct interest payments but not dividend payments, so corporate leverage lowers tax payments

Question 3

MM Proposition II with tax

Answer 3

Rs = R0+ B/S(1-tc)(R0 - Rb)

The cost of equity rises with leverage because the risk to equity rises with leverage

Question 4

Assumptions of MM propositions with taxes

Answer 4

Corporations are taxed at the rate tc, on earnings after interest.
No transaction costs
Individuals and companies borrow at the same rate.

Question 5

Tax shield

Answer 5

Reduction in taxable income e.g deducting interest payments

Question 6

Tax shield =

Answer 6

tc x Rb x B

Question 7

Present value of tax shield

Answer 7

tcB

Question 8

Value of levered firm with taxes MM I

Answer 8

VL = EBIT x (1-tc) + tcB
—————–
Ro

VL = Vu + tcB

Question 9

Unlevered value of firm =

Answer 9

EBIT (1-tc) / R0

Question 10

Relationship between leverage and firm value with corporate taxes

Answer 10

Debt reduces a firms tax burden. As a result, the value of the firm is positively related to debt.

Question 11

WACC with corporate taxes =

Answer 11

S B
— Rs + ——- Rb(1-tc)
VL VL

Question 12

How can we increase leverage from unlevered stocks?

Answer 12

Borrow
Buy additional stocks
Which are levered cash flows

Question 13

How can we decrease leverage from levered stocks?

Answer 13

Sell stocks
So we lend the proceeds out
Which unloved the cash flows