1.+CFP - Study+Guide - v2.0 5

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CORPORATE FINANCE AND PLANNING

The main point with Case I is that it doesn’t matter how we divide our cashflows
between our stockholders and bondholders; the cashflow of the firm doesn’t change.
Since the cash flow doesn’t change, and we haven’t changed the risk of existing
cashflows, the value of the firm doesn’t change.

Here are the graphical illustrations of the M&M Propositions.

With Case I it doesn’t matter how we divide our cash flows between our stockholders
and bondholders; the cash flow of the firm doesn’t change and the WACC doesn’t
change.

M&M Proposition II shows that the firm’ cost of equity can be broken down into two
components. The first component RA is the required return on the firm’s overall assets
and it depends on the nature of the firm’s operating activities. The risk inherent in a
firm’s operations is called the business risk of the firm’s equity.

Business risk is the risk inherent in a firm’s operations; it depends on the systematic
risk of the firm’s assets and it determines the first component of the required return on
equity, RA

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CORPORATE FINANCE AND PLANNING

Financial risk is the extra risk to stockholders that results from debt financing; it
determines the second component of the required return on equity, (RA – RD)(D/E)

Case 2

Case II = Corporate taxes; no personal taxes and no cost to bankruptcy

Debt has two distinguishing features:


• Interest paid on debt is tax deductible
• Failure to meet debt obligation can lead to bankruptcy
We will consider taxes for Case II and the bankruptcy only in Case III.

As interest payment is tax-deductible, it reduces net income but increases cash flow.

CFFA = EBIT – taxes (depreciation expense is the same in either case, so it will not
affect CFFA on an incremental basis)

*CFFA is the Cash Flow From Assets.

Case 2 - Example

Unlevered Levered
U L
EBIT 1,000 1,000
Interest 0 80
Taxable Income 1,000 920
Taxes (30%) 300 276
Net Income 700 644
CFFA 700 724

From simple comparisons, we see the Interest Tax Shield is $24 per year.

The table shows the impact of corporate taxes on net income and cash flow on Firms
U (unlevered = no debt) and Firm L (levered).

The interest tax shield is the tax savings arising from the tax deductibility of interest. It
is the key benefit of borrowing over issuing equity.

If we assume perpetual debt, which makes the computations easier, then the present
value of interest tax savings = D(RD)(TC) / RD = D x TC
Annual interest tax savings = D x (RD) x (TC)

We also assume constant perpetual cash flows to the firm. This is done for simplicity,
but the ultimate result is the same even if you use finite cash flows that vary.

Working out the mathematics,

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