FIN222 Lecture Notes - Lecture 11: Tax Shield, Corporate Tax, Capital Market

39 views2 pages

silverhound358

1 Aug 2018

School

Department

Course

Professor

For unlimited access to Class Notes, a Class+ subscription is required.

Document Summary

+ always include ordinary shares, often include debt and preference shares: financing decision to be made consistent with the goal of maximizing shareholder"s wealth (= firm value) A firm"s debt-to-equity ratio is the fraction of the firm"s total value that correspond to debt: or. Another common measure of capital structure: case 1: perfect capital market (mm world) no tax, cost and dependence of investment cf. Perfect capital market is a market in which: Securities are fairly priced (trade same set of securities at competitive market prices equal to pv of future cf) Investment cash flows are independent of financing choices. Mm1: in a perfect capital market, the total value of a firm is equal to the market value of the fcf generated by its assets and is not affected by its choice of capital structure. Ex: you will need to make an upfront investment of ,000 to start the coffee shop.

Related Questions

Franco Modigliani and Merton Miller (M & M) are two very famous financial economists that both won the Nobel Prize in Economics for their work in the finance area, particularly in capital structure theories (see the Description of this in the box on page 504 of your text). In their famous 1958 article (see footnote on page 490), they argued that with perfect capital markets, the total value of a firm should not depend on its capital structure. In other words, the total value of a frim would be the same with all equity, or financing with 100% debt. This is the basic MM Proposition I stated on p.493. But, as you should see, the "perfect capital markets" assumes 3 key assumptions, including no taxes or transactions costs dealing with equity or debt. Additionally, a key assumption is that individuals and firms can trade the same set of securities at competitive market prices equal to the present value of their future cash flows.

These assumptions are necessary for the M&M theory on capital structure.

For the Proposition M&M II beginning on page 498, still in a perfect capital market which includes no taxes, M&M state that the cost of capital of EQUITY increases with the firm's market value debt-equity ratio. But, when you examine this Proposition more closely, for a new investment the cost of capital will equal the weighted average of the firm's equity and debt costs. What does this mean in practical terms? It means that M&M "loosens" a part of the Proposition I, and admit that the cost of equity does increase as the debt-equity ratio increases. But, if you examine this closely, it means that the OVERALL cost of capital, captured in the WACC stays constant. And, the pre-tax WACC is the same as the after-tax WACC, since there is no tax! If the WACC stays constant while the equity cost increases, this means that the debt costs are going down,relatively; on the contrary, if the equity costs are going down, then the debt costs are going up. This is shown on page 500 in Figure 14.1. And, of course, the weights count.

But, in the real-world, the M&M Propositions do not hold....corporations and individuals do have taxes, and do have transactions costs for debt and equity...buying bonds and stocks, for example.

So, as we have learned, the Beta coefficient for equity does increase as the amount of debt level increases (due to increasing risks of default of interest payments or repayment of the bonds at maturity)...and the costs of debt increase, but as we weight those, the WACC actually varies, based on the real-world that includes taxes....we normally see the WACC being a U-shaped curved that varies as a function of the debt to equity ratio.

That is the background for this Written Assignment. Dr. Steadman

) Discuss the MM Proposition I and MM Proposition II (definition, assumptions, results and implications)? Remember, at the MBA level, more is better. But, to the point, and no "hot air."

Intermediate Financial Management 11th Edition

Chapter 15: Capital Structure Decisions Part 1 Mini Case

Assume you have just been hired as a business manager of PizzaPalace, a regional pizze restaurant chain. The company EBIT was $50 million last year and is not expected to grow. The firm is currently financed with all equity, and it has 10 million shares outstanding. When you took your corporate finance course, your instructor stated that most firms' owners would be financially better off if the firms used some debt. When you suggested this to your new boss, he encouraged you to pursue the idea. As a first step, assume that you obtained from the firm's investment banker the following estimated costs of debt for the firm at different capital structures:

PERCENT FINANCED WITH DEBT, Wd	rd
0%	-
20	8.0%
30	8.5
40	10.0
50	12.0

If the company were to recapitalize, then debt would be issued and the funds received would be used to repurchase stock. PizzaPalace is in the 40% state-plus-federal corprate tax bracket, its beta is 1.0, the risk free rate is 6%, and the market risk premium is 6%.

Please answer All Parts:

Part A: Provide a brief overview of capital structure effects. Be sure to identify the ways in which capital structure can affect the WACC and free cash flows.

Part B: 1) What is business risk? What factors influence a firm's business risk? 2) What is operating leverage, and how does it affect a firm's business risk? Show the operating breakeven point if a company has fixed costs of $200, a sales price of $15, and variable costs of $10.

Part C: Now, to develop an example that can be presented to PizzaPalace's management to illustrate the effects of financial leverage, consider two hypothetical firms: Firm U, which uses no debt financing, and Firm L, which uses $10,000 of 12% debt. Both firms have $20,000 in assets, a 40% tax rate, and an expected EBIT of $3,000. 1) Construct partial income statements, which start with EBIT, for the two firms. 2) Now calculate ROE for both firms. 3) What does this example illustrate about the impact of financial leverage on ROE?

Part D: Explain the difference between financial risk and business risk.

Part E: What happens to ROE for Firms U and L if EBIT falls to $2,000? What does this imply about the impact of leverage on risk and return?

Part F: What does capital structure theory attempt to do? What lessons can be learned from capital structure theory? Be sure to address the MM models.

Part G: What does the empirical evidence say about capital structure theory? What are the implications for managers?

Part H: With the preceding points in mind, now consider the optimal capital structure for PizzaPalace. 1) For each capital structure under consideration, calculate the levered beta, the cost of equity, and the WACC. 2) Now calculate the corporate value for each capital structure.

Part I: Describe the recapitalization process and apply it to PizzaPalace. Calculate the resulting value of the debt that will be issued, the resulting market value of equity, the price per share, the number of shares repurchased, and the remaining shares. Considering only the capital structures under analysis, what is PizzaPalace's optimal capital structure?

graykoala876

Assume you have just been hired as a business manager of pizzapalace.
EBIT was $ 50 million last year not expected to grow.
Currently financed with all Equity.
10 million shares outstanding.
You suggested to your boss to use the debt financing. Heapproved.

Estimated costs of debt for firm are below:

Percent Financed with Debt,wd rd
0% -
20 8.0%
30 8.5%
40 10.0%
50 12.0%

If the company were to recapitalize then debt would be issued andthe funds received would be used to repurchase stock.
federal tax bracket is 40%.
beta is 1.0
risk free rate is 6%
market risk premium is 6%

Required:
a. provide a brief overview of capital structure effects. be sureto identify the ways in which capital structure can affect the WACCand FCF
b. 1. what is business risk? what factors influence a firm'sbusiness risk?
2. what is operating leverage, and how does it affect a firm'sbusiness risk? show the operating break even point if a company hasfixed costs of $ 200, a sales price of $15.00 and variable costs of$ 10.00

c. develop an example to present to pizza palace use these twohypothetical firms:
Firm U
uses no debt financing
assets is $ 20,000
40% tax rate
EBIT is $3,000

Firm L:
uses debt financing
$ 10,000 of 12% debt
assets is $ 20,000
40% tax rate
EBIT is $ 3,000

1. construct partial income statement which starts with EBIT forboth firms
2.calculate ROE for both
3. what is the impact of financial leverage on both firms?
d. Explain the difference between financial risk and businessrisk.
e. what happens to ROE for Firm U and firm L if EBIT falls to $2000? what does this imply about the impact of leverage on risk andreturn?
f. what does capital structure theory attempt to do? what lessonscan be learned from capital structure theory? address MMmodels
g. what does the empirical evidence say about capital structuretheory? what are the implications for managers?
h. with the preceeding points in mind, now consider the optimalcapital structure for Pizza Palace.
1. for each capital structure under construction, calculate thelevered beta, the cost of equity and the WACC.
2. calculate the corporate value for each capital structure.
i. Describe the recapitalization process and apply it to PizzaPalace. Calculate the resulting value of the debt that will beissued, the resulting market value of equity the price per share,the number of shares repurchased, and the remaining shares.Considering only the capital structure under analysis, what isPizza Palace optimal structure?

salmongerbil886

FIN222 Lecture Notes - Lecture 11: Tax Shield, Corporate Tax, Capital Market

Document Summary

Get access

Related Documents

FIN222 Lecture Notes - Lecture 10: Financial Distress, Retained Earnings, Tax Shield

FIN222 Lecture Notes - Lecture 9: Capital Budgeting, Weighted Arithmetic Mean, Preferred Stock

FIN222 Lecture Notes - Lecture 1: Financial System, Double Taxation, Public Company

Related Questions