COMM 122 Study Guide - Midterm Guide: Full-Time Equivalent, Net Present Value, Preferred Stock

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7 Feb 2014
Finance II Midterm Exam Review
Chapter 16.1-16.6 / Lecture 1 & 2
Pie model – the value of the firm is the sum of the financial claims of the firm (market values of
debt and equity in this case)
V = B + S
-changes in capital structure benefit the shareholders if and only if the value of the firm increases
(and vice versa)
The above graph shows the break even point. The dotted line represents the case for having debt,
while the solid line represents the no leverage case (begins at the origin since the EPS would be
zero). For the case with debt, EPS is negative if EBIT is zero since the interest must be paid
regardless of the firm’s profits. The slope of the dotted line is higher than the slope of the solid
line since the levered firm has fewer shares of stock outstanding than the unlevered firm, so any
increase in EBIT leads to a greater rise in EPS for the levered firm. The intersection point is the
BEP where there is no advantage or disadvantage to debt and the EPS under each scenario would
be the same
Residual rights – shareholders get whatever’s left over of firm value after debt payback
MM Proposition 1 without taxes – a firm cannot change the total value of its outstanding
securities by changing the proportions of its capital structure (the V is always the same under
different capital structures)
-through homemade leverage, individuals can either duplicate or undo the effects of corporate
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-assumption that individuals can borrow as cheaply as corporations
Homemade leverage – if levered firms are priced too high, rational investors will arbitrage by
borrowing on their personal accounts to buy shares in unlevered firms to duplicate the effects of
corporate leverage. Eventually the value of the levered firm would fall and the value of the
unlevered firm would rise until they were at an equilibrium and investors would be indifferent
between using homemade leverage or not.
MM Proposition 2 without taxes – levered equity has greater risk, and therefore has a greater
expected return as compensation. The expected return on equity is positively related to leverage
because the risk to equityholders increases with leverage
rs = ro +
Rothe cost of capital for an all-equity firm
Ro = expected earnings to unlevered firm / unlevered equity
-the firm’s cost of capital cannot be reduced as debt is substituted for equity since as the firm
adds debt the equity remaining becomes more risky, increasing the cost of equity capital. It
becomes more risky because the firm will have a higher and higher interest payment to make.
This offsets the higher proportion of the firm that is financed by low cost debt so that both the
value of the firm and the firm’s overall cost of capital are invariant to leverage (no taxes!)
-view firm as a pie, the size of the pie does not change no matter how shareholders and
bondholders divide it
-both propositions without taxes also assume no transaction costs, individuals and corps borrow
at same rate, complete info, perpetual cash flow and no default risk
Present Value of the Tax Shield
The dollar interest from debt is interest rate x amount borrowed (rB x B)
All the interest is tax deductible – the corporation does not pay taxes on the debt – so you must
add back the tax times the dollar amount of interest for the tax shield
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Dollar reduction in corporate taxes = Tc x rB x B
We can assume that the cash flow of tax shield has the same risk as the interest on the debt and
can discount the annual cash flows to find the present value of the tax shield
If the cash flows are perpetual, PV tax shield =
= TcB
MM Proposition 1 (with taxes) – the value of the firm is the value of an all equity firm plus the
present value of the tax shield in the case of perpetual cash flows. This means that the firm can
raise its total cash flow by substituting debt for equity since the tax shield increases with the
amount of debt
-since corps can deduct interest payments but not dividend payments, corporate leverage lowers
tax payments
VL =
MM Proposition II (with taxes) – a positive relationship still exists between the expected return
on equity and leverage. This result occurs because the risk of equity increases with leverage
-ro must be > rB (hold for with and without taxes, but should be true since equity is risky and
should have a higher expected return than less risky debt)
rS = rO +
(1 – Tc)(rO – rB)
-in the no tax case, WACC Is not affected by leverage
-in a world with corporate taxes, WACC declines with leverage
-when a firm announces that in the near future it will issue debt to buy back stock, the value of
the firm will rise immediately to reflect the tax shield of debt (on the day of announcement, not
the day of the debt for equity exchange)
-the firm will buy back the shares at the price that reflects the announcement (equity will
increase by value of tax shield as well since balance sheet must balance and so share price
-the price of the stock won’t change on the exchange date
MM propositions with taxes assume that corps are taxes at Tc on earnings after interest, no
transaction costs, individuals and corporations borrow at the same ate, complete info, perpetual
cash flows, no default risk
Chapter 31.1-31.6 / Lecture 3
Financial distress – occurs when a firm’s operating cash flows are not sufficient to satisfy
current obligations such as trade credits or interest expense and the firm is forced to take
corrective actions. Could include dividend reduction, plant closings, losses, layoffs etc.
-can restructure assets (sell assets, mergers) or finances (bankruptcy, reorganization)
Recovery of par – the faction of dollar amount recovered to the face value of debt, depends on
debt seniorities, collateral, ratings, state of economy, firm’s financial conditions etc.
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