CF-II

Session 2

Capital Structure Decision

With Taxes
 The Modigliani-Miller Model
without Corporate Taxes
• Proposition I
Firm value is not affected by leverage
VL = VU
• Proposition II
Leverage increases the risk and return to stockholders
rs = r0 + (B / SL) (r0 - rB)
• rB is the interest rate (cost of debt)
• rs is the return on (levered) equity (cost of equity)
• r 0 is the return on unlevered equity (cost of capital)
• B is the value of debt
• SL is the value of levered equity
 MM Proposition II with
Cost of capital: r (%) No Corporate Taxes
B
rS  r0   (r0  rB )
SL

B S
rW ACC   rB   rS
r0 BS BS

rB rB

B
Debt-to-equity Ratio S
 What is Acetate's debt-equity ratio!
Acetate, Inc., has equity with a
market value of $20 million and Debt-Equity Ratio = Market Value of Debt /
debt with a market value of $10 Market Value of Equity
million. = $10 million / $20 million = ½
The cost of the debt is 14 percent
per annum. What is the firm's wacc!
Treasury bills that mature in one rwacc = {B / (B+S)} rB + {S / (B+S)}rS
year yield 8 percent per annum,
and the expected return on the
market portfolio over the next rS = rf + bS{E(rm) – rf}
year is 18 percent. = 0.08 + 0.9( 0.18 – 0.08) = 0.17
The beta of Acetate's equity is
0.9.The firm pays no taxes.
rwacc = {B / (B+S)} rB + {S / (B+S)}rS
a. What is Acetate's debt-
equity ratio! = ($10/$30)(0.14) + ($20/ $30)(0.17)
b. What is the firm's weighted = 0.16
average cost of capital!
c. What is the cost of capital Whatequity
is the cost of capital for an identical all-
firm!
for an otherwise identical
all-equity firm! rS = r0 + (B/S)(r0 – rB)
0.17 = r0 + (1/2)(r0 – 0.14)
Solving :r0 = 0.16
Locomotive Corporation is planning What is the market value of Locomotive Corporation before
to repurchase part of its common and after the repurchase announcement!
stock by issuing corporate debt.
B = $7.5 million and B/S = 40%:
As a result, the firm's debt-to-equity
ratio is expected to rise from 40 ($7.5 million / S)= 0.40, S = $18.75 million
percent to 50 percent. The firm VL = B + S, = $7.5 m + $18.75 m = $26.25 million
currently has $7.5 million worth of
debt outstanding.
The cost of this debt is 10 percent What is the expected return on the firm's equity (rs) before the
per annum. Locomotive expects to announcement of the stock repurchase plan!
earn (before Interest & taxes) $3.75 Earning before interest =$3,750,000
million per annum in perpetuity. Interest = $7,500,000 x 0.10 = $ 750,000
Locomotive pays no taxes. Earning after interest = $3,000,000
a. What is the market value of rs = Earning / S = $3m/$18.75m = 0.16
Locomotive Corporation
before and after the What is the expected return on the equity of an otherwise
repurchase announcement! identical all-equity firm (r0).
b. What is the expected return rS = r0 + (B/S)(r0 – rB)
on the firm's equity (rs)
before the announcement of 0.16 = r0 + ($7.5 m/ $18.75 m(r0 – 0.10)
the stock repurchase plan! Solving :r0 = 0.1429
c. What is the expected return
on the equity of an otherwise What is the expected return on the firm's equity (rs) after the
identical all-equity firm (r0). announcement of the stock repurchase plan!
d. What is the expected return rS = r0 + (B/S)(r0 – rB)
on the firm's equity (rs) after
the announcement of the = 0.1429+ (0.50)(0.1429 – 0.10) = 0.1644
stock repurchase plan!
 Capital Structure

The Modigliani-Miller Model

With Corporate Taxes
 The Modigliani-Miller Model
with Corporate Taxes
Your Company having assets of Rs.8000 has no debt in its capital
structure (an unlevered company). The company issued 400 shares
each values Rs. 20 in the market.

The company has now proposed to issue a 10% per annum debt
instrument of Rs 4000 to buyback 50% of the share issued (becomes a
levered company).

The company has earned ROA of 15%.

The applicable corporate tax rate for the company is 40%.

Analyse benefits to the investors.

 The MM Propositions I & II
(with Corporate Taxes)
• Proposition I (with Corporate Taxes)
– Firm value increases with leverage
VL = VU + TC B
• Proposition II (with Corporate Taxes)
– Some of the increase in equity risk and return is offset
by interest tax shield
rS = r0 + (B/S) ×(1-TC) ×(r0 - rB)
rB is the interest rate (cost of debt)
rS is the return on equity (cost of equity)
r0 is the return on unlevered equity (cost of capital)
B is the value of debt
S is the value of levered equity
The Effect of Financial Leverage on the Cost of Debt
and Equity Capital with Corporate Taxes
Cost of capital: r B
(%) rS  r0   (r0  rB )
SL
B
rS  r0   (1  TC )  (r0  rB )
SL

r0 B SL
rW ACC   rB  (1  TC )   rS
BSL B  SL

rB

Debt-to-equity
ratio (B/S)
 Value of a Firm
• Annual Cash Flow of Unlevered Firm
– EBIT – Taxes
– EBIT(1-Tax Rate)
• Value of Unlevered Firm VU
– EBIT(1-Tc)/r0
• Value of a Levered Firm VL
– Value of Unlevered Firm + Tax Shield
– EBIT(1-Tc)/r0 + Tc . B
 Q1
Gibson, Inc., expects • VL = V U + T C B
perpetual earnings before VU = [(EBIT)(1-TC)] / r0
interest and taxes of $1.2
million per year. The firm's = [($1,200,000)(1 - 0.35)] / 0.12
pretax cost of debt is 8 = $6,500,000
percent per annum, and its
annual interest expense is V L = V U + T CB
$200,000. Company
= $6,500,000 + (0.35)($2,500,000) = $7,375,000
analysts estimate that the
unlevered cost of Gibson's
equity is 12 per­cent. Gibson • If there are no costs of financial distress or
is subject to a 35 percent bankruptcy, increasing the level of debt in a firm’s
corporate tax rate. capital structure will always increase the value of a
a. What is the value of this firm. This implies that every firm will want to be
firm? financed entirely (100%) by debt if it wishes to
b. If there are no costs of maximize its value.
financial distress or
bankruptcy, what •
percentage of the firm's This conclusion is not applicable in the real world
capital structure would be since it does not consider costs of financial
financed by debt? distress, bankruptcy, or other agency costs that
c. Is the conclusion in (b) might offset the benefit of increased leverage.
applicable to the real These costs will be discussed in further detail in
world? later sessions.
• The Holland Company
Q2
• VL = V U + T C B
expects perpetual earnings
before interest and taxes VU = [(EBIT)(1-TC)] / r0
(EBIT) of $4 million per = [($4,000,000)(1 - 0.35)] / 0.15
year. The firm's after-tax, = $17, 333, 333
all-equity discount rate (ro)
is 15 percent. Holland is
subject to a corporate tax VL = VU + T CB
rate of 35 percent. The
pretax cost of the firm's = $17,333,333+ (0.35)($10,000,000) =
debt capital is 10 percent $20,833,333
per annum, and the firm
has $10 million of debt in • rS = r0 + (B/S)(r0 – rB)(1 – TC)
its capital structure.
a. What is Holland's value? = 0.15 + ($10,000,000 / $10,833,333)(0.15 –
b. What is Holland's cost of 0.10)(1 – 0.35)
equity (rs)? = 0.15 + (0.9230)(0.15-0.10)(1 – 0.35) = 0.18
c. What is Holland's weighted
average cost of capital
(rWACC)? • rwacc= {B / (B+S)}(1 – TC) rB + {S / (B+S)}rS
= ($10,000,000 / $20,833,333)(1 – 0.35)(0.10) +
($10,833,333 / $20,833,333)(0.18)
= (0.48)(1 – 0.35)(0.10) + (0.52)(0.18) = 0.1248
 Q3.
Nagpur Manufacturing is currently an all
equity company with 20 million shares
outstanding and a stock price of Rs.
7.50 per share. Although investors Value of Company = No. of
currently expect the company to
maintain its all equity status, the shares o/s x Share Price
company has announced to borrow Rs. = 20 m x Rs. 7.50 = Rs. 150 m
50 million @ 10% p.a. and use the
funds to repurchase shares. The
company will only pay interest. The
corporate tax rate is 40%.
a. What is the market value of company’s VL = VU + TCB
asset before announcement?
= 150m + 0.40x50 = Rs. 170m
b. What is the market value of company’s
asset after shares are repurchased?
Company Value = Rs. 170m
c. What price the company should pay for No. of shares o/s = 20m
share repurchase?
Value per share = Rs. 170m/20m
= Rs. 8.50
 Quiz
Your company is currently an all equity company with
assets worth Rs. 25 billion and (10+X) million shares
outstanding. The company has announced to borrow
Rs. (X+Y) billion and will pay 10% interest per year. The
funds will be used to repurchase shares. The company
will only pay interest. The corporate tax rate is (30+X)%.

What price the company should pay for share repurchase?

• X= Unit place digit of your roll no

• Y= Tenth place digit of your roll no.