Académique Documents
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John and Cindy set up a new United Widgets is financed with 1. If there are no tax
company--United Widgets, Inc. equity (meaning: money put up discount rate.
They decide to buy a widget by John and Cindy and their
machine because financial friends) and debt (money 2. If there are only c
analysis shows that the NPV of borrowed from the bank). means that the widge
the machine's cash flows is
positive. 3. If both personal a
rates can increase/d
More debt in the debt/equity mix always makes equity riskier! The equity owners have to pay debt hold
they pay themselves and this increases their risk.
The effect of capital structure on WACC depends on the mix of corporate and personal taxes:
1. If there are no taxes, WACC is unaffected by capital structure: the increase in the cost of equity as t
debt/equity mix increases exactly offsets the savings of cheaper debt.
2. If there are only corporate taxes, WACC decreases when more debt is used to finance the firm.
3. If there are both corporate and personal taxes, WACC can increase/decrease/stay same. Empirical
(Chapter 19) seems to indicate that it doesn't change much.
1. If there are no taxes, WACC is unaffected by capital structure: the increase in the cost of equity as t
debt/equity mix increases exactly offsets the savings of cheaper debt.
2. If there are only corporate taxes, WACC decreases when more debt is used to finance the firm.
3. If there are both corporate and personal taxes, WACC can increase/decrease/stay same. Empirical
(Chapter 19) seems to indicate that it doesn't change much.
EFFECT OF DEBT/EQUITY MIX ON WEIGHTED AVERAGE COST OF
CAPITAL (WACC)
1. If there are no taxes, the debt/equity mix does not affect the widget-machine
discount rate.
2. If there are only corporate taxes and no personal taxes, then more debt
means that the widget discount rate decreases.
3. If both personal and corporate incomes are taxed, widget machine discount
rates can increase/decrease/stay same when the debt/equity mix changes.
1. If there are no taxes, the debt/equity mix does not affect the total amount of
cash extracted from the company.
2. If there are only corporate taxes and no personal taxes, then more debt
means more cash extracted from the company; happens because the tax
system subsidizes debt (interest is an expense for tax purposes).
3. If both personal and corporate incomes are taxed, the cash extracted from
the company can go up or down: Companies enjoy a tax subsidy on their
interest payments (since interest is an expense for tax purposes). But
shareholders pay lower taxes on earnings from equity (because of an
advantageous capital gains tax) than on interest earnings from debt.
CC
personal taxes:
FCF = $1000
Equity income =
$1000 - 8%*3,000*(1-40%) = $856
Paid to Arthur ABC, sole owner
8%*$3000 = $240
Arthur: $ 856
Mom: $ 240
Total: $ 1096
Company Arthur
borrows borrows
FCF, after personal tax 1,000.00 1,000.00
Corporate debt 4,000.00 0.00
Corporate cost of debt 320.00 0.00
Payout to equity owners 808.00 1,000.00 #VALUE!
Arthur's income
Equity income from XYZ 808.00 1,000.00 #VALUE!
Arthur's debt 0.00 4,000.00
Arthur's cost of debt 0.00 320.00 #VALUE!
Arthur's income 808.00 680.00 #VALUE!
Company Arthur
Debt borrows borrows
0 1,000 1,000
500 1,016 1,000
1,000 1,032 1,000
1,500 1,048 1,000
2,000 1,064 1,000
2,500 1,080 1,000
3,000 1,096 1,000
3,500 1,112 1,000
4,000 1,128 1,000
4,500 1,144 1,000
0 500 1,0001,5002,0002,5003,00
RCHASE OF ABC
no personal taxes
FCF = $1000
Arthur's mother. No personal Arthur ABC -- sole owner of all ABC's Arthur's mother. No personal
tax. equity. Borrowed $3000 of perpetual tax. Gets interest from Arthur.
debt from Mom at 8%. No personal tax,
Annual after-tax income: but owes Mom interest
Annual 8%*$3000 = $240
8%*$3000 = $240 Annual income =
$1,000 - 8%*$3,000 = $760
Arthur: $ 760
Mom: $ 240
Total: $ 1000
Company
borrows
Arthur
borrows
500 1,0001,5002,0002,5003,0003,5004,0004,5005,000
other. No personal
nterest from Arthur.
*$3000 = $240
A B
IGLIANI-MILLER
1 MODEL WITH ONLY
RATE TAXES
2
3
4
5
6
7
8
9 #VALUE!
10 #VALUE!
11 #VALUE!
12
13 #VALUE!
14
15 #VALUE!
16 #VALUE!
17
18 #VALUE!
19
20
21 #VALUE!
22 #VALUE!
A B C
1 THE WONDERTURF TURFING MACHINE
2 TC, corporate tax rate 40%
3
4 Machine cost, year 0 100,000
5
6 Free cash flow (FCF) calculation
7 Additional sales, annually 40,000
8 Additional annual cost of sales 15,000
9 Annual depreciation 10,000 #VALUE!
10 Annual FCF, years 1-10 19,000 #VALUE!
11
12 Discount rate for machine FCFs 15%
13
Machine
14
Year FCF
15 0 -100,000 #VALUE!
16 1 19,000 #VALUE!
17 2 19,000
18 3 19,000
19 4 19,000
20 5 19,000
21 6 19,000
22 7 19,000
23 8 19,000
24 9 19,000
25 10 19,000
26
27 Machine NPV -4,643 #VALUE!
28
29 NPV: Machine + Loan 6,093 #VALUE!
D E F
NDERTURF
1 TURFING MACHINE
2
3
4
5
6
7
8
9
10
11
12 Loan to buy machine 50,000
13 rD, loan interest rate 8%
14
Loan CFs
15 50,000 #VALUE!
16 -2,400 #VALUE!
17 -2,400
18 -2,400
19 -2,400
20 -2,400
21 -2,400
22 -2,400
23 -2,400
24 -2,400
25 -52,400 #VALUE!
26
27 Loan NPV 10,736 #VALUE!
28
29
A B
1 POTFOOLER--DEBT ISSUED TO REPURCHASE SHARES
2 Unlevered company
3 Annual free cash flow (FCF) $2,000,000
4 Number of shares 100,000
5 Price per share $100
6 Total equity value $10,000,000
7
8 Question 1: VU, unlevered value of Potfooler $10,000,000
9
10 Levered company
11 Debt issued $3,000,000
12 Interest rate on debt 8%
13 TC, Lower Fantasia corporate tax rate 40%
14 Question 2: VL, levered value of Potfooler, VL = VU + TC*D $11,200,000
15 Question 3: Equity value after share repurchase, E = V L - D $8,200,000
Incremental firm value from exchanging
16 equity by debt = VL - VU = TC*D $1,200,000
17 Incremental firm value on a per-share basis $12
18 Question 4: New share value, after repurchase $112
19
Question 5: Number of shares repurchased =
20
[debt used for repurchase]/[new share value] 26,785.71
Number of shares remaining after
21 repurchase = original number of shares
minus number of shares repurchased 73,214.29
Check: Market value of remaining shares =
22
number of remaining shares * new share value $8,200,000
23
Question 6: Potfooler's cost of equity when unlevered,
24 rU=FCF/VU 20.00%
25
26 Annual interest costs, before taxes $240,000
27 Annual equity cash flow, after interest = FCF - (1-TC)*interest $1,856,000
Question 7: Potfooler's cost of equity when levered,
28 rE(L)=[FCF-(1-TC)*interest]/[value of equity, E] 22.63%
29
30 Question 8: Potfooler's WACC before the debt issuance = r U 20.00%
31
Question 9: Potfooler's WACC after the debt issuance
32 = rE(L)*E/(E+D)+rD*(1-TC)*D/(E+D)
33 Percentage of equity in Potfooler = E/(E+D) 73.21%
34 Percentage of debt in Potfooler = D/(E+D) 26.79%
35 WACC = rE(L)*E/(E+D)+rD*(1-TC)*D/(E+D) 17.86%
36
37
A B
38
Debt issued
39 Levered value VL as a function of firm debt
40 0
41 14,000,000 1,000,000
42 2,000,000
43 13,000,000 3,000,000
44 4,000,000
12,000,000 5,000,000
45
46 6,000,000
11,000,000
47 Debt 7,000,000
48 10,000,000 8,000,000
49 9,000,000
0
1,000,000
2,000,000
3,000,000
4,000,000
5,000,000
6,000,000
7,000,000
8,000,000
9,000,000
50
51
52
C D E F G H
RCHASE SHARES
1
2
3
4
5
6 #VALUE!
7
8 #VALUE!
9
10
11
12
13
14 #VALUE!
15
16
#VALUE!
17 #VALUE!
18 #VALUE!
19
20
#VALUE!
21
#VALUE!
22
#VALUE!
23
24
25
26 #VALUE!
27 #VALUE!
28
#VALUE!
29
30
31
32
33 #VALUE!
34 #VALUE!
35 #VALUE!
36
37
C D E F G H
Cost of
38 Value of levered firm, equity
VL = VU + TC*D rE(L) WACC
39 <-- Data table headers, hidden
40 10,000,000 20.00% 20.00%
41 10,400,000 20.77% 19.23%
42 10,800,000 21.64% 18.52%
43 11,200,000 22.63% 17.86%
44 11,600,000 23.79% 17.24%
45 12,000,000 25.14% 16.67%
46 12,400,000 26.75% 16.13%
47 12,800,000 28.69% 15.63%
48 13,200,000 31.08% 15.15%
49 13,600,000 34.09% 14.71%
50
51
52
A B
1 POTFOOLER--DEBT ISSUED TO REPURCHASE SHARES, corporate tax rat
2 Unlevered company
3 Annual free cash flow (FCF) $2,000,000
4 Number of shares 100,000
5 Price per share $100
6 Total equity value $10,000,000
7
8 Question 1: VU, unlevered value of Potfooler $10,000,000
9
10 Levered company
11 Debt issued $3,000,000
12 Interest rate on debt 8%
13 TC, Lower Fantasia corporate tax rate 0%
14 Question 2: VL, levered value of Potfooler, VL = VU + TC*D $10,000,000
15 Question 3: Equity value after share repurchase, E = V L - D $7,000,000
Incremental firm value from exchanging
16 equity by debt = VL - VU = TC*D $0
17 Incremental firm value on a per-share basis $0
18 Question 4: New share value, after repurchase $100
19
Question 5: Number of shares repurchased =
20
[debt used for repurchase]/[new share value] 30,000.00
Number of shares remaining after
21 repurchase = original number of shares
minus number of shares repurchased 70,000.00
Check: Market value of remaining shares =
22
number of remaining shares * new share value $7,000,000
23
Question 6: Potfooler's cost of equity when unlevered,
24 rU=FCF/VU 20.00%
25
26 Annual interest costs, before taxes $240,000
27 Annual equity cash flow, after interest = FCF - (1-TC)*interest $1,760,000
Question 7: Potfooler's cost of equity when levered,
28 rE(L)=[FCF-(1-TC)*interest]/[value of equity, E] 25.14%
29
30 Question 8: Potfooler's WACC before the debt issuance = r U 20.00%
31
Question 9: Potfooler's WACC after the debt issuance
32 = rE(L)*E/(E+D)+rD*(1-TC)*D/(E+D)
33 Percentage of equity in Potfooler = E/(E+D) 70.00%
34 Percentage of debt in Potfooler = D/(E+D) 30.00%
35 WACC = rE(L)*E/(E+D)+rD*(1-TC)*D/(E+D) 20.00%
C
ARES, corporate
1 tax rate = 0%
2
3
4
5
6 #VALUE!
7
8 #VALUE!
9
10
11
12
13
14 #VALUE!
15
16
#VALUE!
17 #VALUE!
18 #VALUE!
19
20
#VALUE!
21
#VALUE!
22
#VALUE!
23
24
25
26 #VALUE!
27 #VALUE!
28
#VALUE!
29
30
31
32
33 #VALUE!
34 #VALUE!
35 #VALUE!
FIN
Upper Fan
Personal taxes: Tax o
Arthur: $ 770.40
Mom: $ 168.00
Total: $ 938.40
Arthur's income
Pre-tax equity income from XYZ 856.00 1,000.00 #VALUE!
Post-tax equity income from XYZ 770.40 900.00 #VALUE!
Arthur's debt 0.00 3,000.00
Arthur's pre-tax interest payment 0.00 240.00 #VALUE!
Arthur's after-tax interest payment 0.00 168.00
Arthur's post-tax income 770.40 732.00 #VALUE!
Company Arthur
Debt borrows borrows
<-- Data table header
0 900 900
500 906 900
1,000 913 900
1,500 919 900
2,000 926 900
2,500 932 900
3,000 938 900
3,500 945 900
4,000 951 900
4,500 958 900
0 500 1,000 1,500 2,000
Graph title
Debt (1-TD)-(1-TE)*(1-TC)
FINANCING ARTHUR'S PURCHASE OF XYZ
Upper Fantasia tax code: Corporate income tax, TC = 40%,
ersonal taxes: Tax on equity income, TE = 10%, Tax on all other income, TD = 30%
Arthur's mother. Gets $300 Arthur XYZ -- sole owner of XYZ's equity. Borrowed
interest from Arthur. Personal tax $3000 of perpetual debt from Mom at 8%. Interest
on interest income, TD = 30%. payments create 30% tax shield.
Personal tax on equity income, TE = 10%.
Annual after-tax income: = 30%. Interest is an ordinary-income expense; tax rate
8%*$3000*(1-30%) = $168 on ordinary income, TD = 30%.
Annual income
=$1000*(1-10%)- 8%*3000*(1-30%)= 732
hur + Mom
Arthur: $ 732.00
Mom: $ 168.00
Total: $ 900.00
<-- Data table header
Company
borrows
Arthur
borrows
0 500 1,000 1,500 2,000 2,500 3,000 3,500 4,000 4,500 5,000
%,
ome, TD = 30%
Annual income =
8%*$3000*(1-30%) = $168
+ Mom
A B C
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18
19
20
21
22
23
24
25
26
27
28
29
30
31
32
33
34
35
36
37
38
39
40 Company
borrows
Arthur
borrows
I J K CompanyL M N O
41 borrows
42 Arthur
43 borrows
44
45
46
47
48
49 3,500 4,000 4,500 5,000
2,000 2,500 3,000
50
51
52
53
54
A B C
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18
19
20
21
22
23
24
25
26
27
28
29
30
31
32
33
34
35
36
37
38
39
Company
borrows
Arthur
borrows
I J K L M N O
40 Company
41 borrows
42 Arthur
43 borrows
44
45
46
47
48
49 3,500 4,000 4,500 5,000
2,000 2,500 3,000
50
51
52
53
54
XYZ CORP--ARTHUR AND MOM'S INCOME
XYZ Corp
Each $ of before tax interest paid by XYZ Each $ of interest paid by the company
decreases Arthur's income from the increases Mom's income by (1-TD)
company by (1-TC)*(1-TE)
If this is positive, it's good for the family and the firm should
increase its borrowing; if its negative, it's bad for the family and
the firm should decrease its borrowing.
C IN THE MILLER
1 MODEL
nd personal taxes
2
3
4
5
6
7
8
9
10 #VALUE!
11 #VALUE!
12
13
14 #VALUE!
15 #VALUE!
16 #VALUE!
17
18 #VALUE!
19
20 #VALUE!
21 #VALUE!
22
23 #VALUE!
24
25
26 #VALUE!
27 #VALUE!
28 #VALUE!
A B C
1 THE SONDERTURF STURFING MACHINE
2 TC, corporate tax rate 40%
3 TE, personal tax rate on equity 22%
4 TD, personal tax rate on debt 8%
5
6 Machine cost, year 0 100,000
7
8 Free cash flow (FCF) calculation
9 Additional sales, annually 40,000
10 Additional annual cost of sales 15,000
11 Annual depreciation 10,000 #VALUE!
12 Annual FCF, years 1-10 19,000 #VALUE!
13
14 Discount rate for machine FCFs 15%
15
16
17
Machine
18
Year FCF
19 0 -100,000 #VALUE!
20 1 19,000 #VALUE!
21 2 19,000
22 3 19,000
23 4 19,000
24 5 19,000
25 6 19,000
26 7 19,000
27 8 19,000
28 9 19,000
29 10 19,000
30
31 Machine NPV -4,643 #VALUE!
32
33 NPV: Machine + Loan 5,636 #VALUE!
D E F
ONDERTURF
1 STURFING MACHINE
2
3
4
5
6
7
8
9
10
11
12
13
14 Loan to buy machine 50,000
15 rD, loan interest rate 8%
Net annual advantage of debt
16 financing, (1-TD)-(1-TE)*(1-TC) 45% #VALUE!
17
18
Loan CFs
19 50,000 #VALUE!
20 -2,192 #VALUE!
21 -2,192
22 -2,192
23 -2,192
24 -2,192
25 -2,192
26 -2,192
27 -2,192
28 -2,192
29 -52,192 #VALUE!
30
31 Loan NPV 10,279 #VALUE!
32
33
A B C
16
17
Machine
18
Year FCF
19 0 -100,000 #VALUE!
20 1 19,000 #VALUE!
21 2 19,000
22 3 19,000
23 4 19,000
24 5 19,000
25 6 19,000
26 7 19,000
27 8 19,000
28 9 19,000
29 10 19,000
30
31 Machine NPV -4,643 #VALUE!
32
33 NPV: Machine + Loan -23,526 #VALUE!
D E F
1
SMOTFOOLER--DEBT ISSUED TO REPURCHASE SHARES
Smotfooler is located in Upper Fantasia
2 Upper Fantasia tax system
3 TC, Upper Fantasia corporate tax rate 40%
4 TE, Upper Fantasia personal tax rate on equity income 10%
5 TD, Upper Fantasia personal tax rate on ordinary income 30%
6 Annual debt advantage: (1-TD)-(1-TE)*(1-TC) 16%
7 PV of debt advantage: T = (1-TD)-(1-TE)*(1-TC)/(1-TD) 22.86%
8
9 Unlevered company
10 Annual free cash flow (FCF) $2,000,000
11 Number of shares 100,000
12 Price per share $100
13 Total equity value $10,000,000
14
15 Question 1: VU, unlevered value of Smotfooler $10,000,000
16
17 Levered company
18 Debt issued $3,000,000
19 Interest rate on debt 8%
20 Question 2: VL, levered value of Smotfooler, VL = VU + T*D $10,685,714
21 Question 3: Equity value after share repurchase, E = V L - D $7,685,714
Incremental firm value from exchanging
22 equity by debt = VL - VU = T*D $685,714
23 Incremental firm value on a per-share basis $7
24 Question 4: New share value, after repurchase $107
25
Question 5: Number of shares repurchased =
26
[debt used for repurchase]/[new share value] 28,074.87
Number of shares remaining after
27 repurchase = original number of shares
minus number of shares repurchased 71,925.13
Check: Market value of remaining shares =
28
number of remaining shares * new share value $7,685,714
29
Question 6: Smotfooler's cost of equity when unlevered,
30 rU=FCF/VU 20.00%
31
32 Annual interest costs, before taxes $240,000
33 Annual equity cash flow, after interest = FCF - (1-T C)*interest $1,856,000
Question 7: Smotfooler's cost of equity when levered,
34 rE(L)=[FCF-(1-TC)*interest]/[value of equity, E] 24.15%
Note: See formula in row 44 below for another
35
way to compute the levered cost of equity
36
37 Question 8: Smotfooler's WACC before the debt issuance = rU 20.00%
38
A B
Question 9: Smotfooler's WACC after the debt issuance
39 = rE(L)*E/(E+D)+rD*(1-TC)*D/(E+D)
40 Percentage of equity in Smotfooler = E/(E+D) 71.93%
41 Percentage of debt in Smotfooler = D/(E+D) 28.07%
42 WACC = rE(L)*E/(E+D)+rD*(1-TC)*D/(E+D) 18.72%
43
44 Additional formula: rE(L)=rU+[rU*(1-T)-rD*(1-TC))*D/E 24.15%
C
URCHASE 1SHARES
r Fantasia
2
3
4
5
6 #VALUE!
7 #VALUE!
8
9
10
11
12
13 #VALUE!
14
15 #VALUE!
16
17
18
19
20 #VALUE!
21
22
#VALUE!
23 #VALUE!
24 #VALUE!
25
26
#VALUE!
27
#VALUE!
28
#VALUE!
29
30
31
32 #VALUE!
33 #VALUE!
34
#VALUE!
35
36
37
38
C
39
40 #VALUE!
41 #VALUE!
42 #VALUE!
43
44 #VALUE!
A B
URCHASE SHARES
0%. 1
to debt
2
3
4
5
6 #VALUE!
7 #VALUE!
8
9
10
11
12
13 #VALUE!
14
15 #VALUE!
16
17
18
19
20 #VALUE!
21
22
#VALUE!
23 #VALUE!
24 #VALUE!
25
26
#VALUE!
27
#VALUE!
28
#VALUE!
29
30
31
32 #VALUE!
33 #VALUE!
34
#VALUE!
35
36
37
C
38
39 #VALUE!
40 #VALUE!
41 #VALUE!
A B C
1 WHAT ARE THE RELATIVE TAX EFFECTS
2 Corporate tax rate, TC 37%
3
4 Anticipated equity tax Tax rate
5 Dividend yield 5.00% 0%
6 Capital gains yield 0.00% 0%
7
8 Net after-tax yield 5.00% #VALUE!
9 Before tax yield 5.00% #VALUE!
10
11 Personal tax rate on equity income, T E 0.00% #VALUE!
12 Personal tax rate on ordinary income, TD 0.00%
13
Tax advantage of debt
14 over equity: (1-TD)-(1-TC)*(1-TE) 37.00% #VALUE!