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

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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

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(ro−rB)

Ro – the 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

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(1−TC)

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