COMM 122 Study Guide - Final Guide: Greenshoe, Full-Time Equivalent, Net Present Value

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7 Apr 2014
Department
Course
Finance II Final Exam Review
Shannon Bailey
2014
Pre-Midterm Material
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
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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 leverage
-assumption that individuals can borrow as cheaply as corporations
VL = VU
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 +
B
S(rorB)
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
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-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
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 =
TcrBB
rB
= 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 =
EBIT x(1TC)
ro
+TcrbB
rb
VL = VU + TCB
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 +
B
S
(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 increased)
-the price of the stock won’t change on the exchange date
MM propositions with taxes assume that corps are taxed 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
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