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Finc361 - Lecture - 8 - Leverage and WACC PDF
Finc361 - Lecture - 8 - Leverage and WACC PDF
FINC361 Fall2016
Professor Mahdi Mohseni
Financed
by
Equity
E
D
rE +
rD
E + D
E + D
Cost
of
Capital
Financed
by
Debt
where:
1. E = Market value of equity
2. D = Market value of debt
Market value of debt Book value of debt
Debt
Cost
of
Capital
Wait a minute
Usually: Cost of debt << cost of equity
Example: Southwest
YTM = 3.25%
From Yahoo! Finance: Beta = 1.23
Rf = current YTM of a 10-year U.S. government bond
Market risk premium = 5%
CAPM: E(R)= Rf+beta*[Rm-Rf]= 2% + 1.23*5% = 8.15%
rD << rE
Between 2000
and 2001,
there was a
40% drop in
free cash flows
100.00
10.00
1.00
1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011
Cash Flow To Equity
$100.00
$10.00
$100.00
Axis Title
Between 2000
and 2001, there
was a 40% drop
in free cash
flows
$10.00
Between 2000
and 2001, that
same drop
corresponds to a
90% drop in cash
flows left for the
remaining equity
portion!
$1.00
Modigliani-Miller
The ModiglianiMiller theorem (of Franco Modigliani, Merton
Miller) is a theorem on capital structure, arguably forming the
basis for modern thinking on capital structure.
Assumptions: There are no taxes, bankruptcy costs, agency
costs, and asymmetric information
Proposition I
The basic theorem states that under certain assumptions the
value of a firm is unaffected by how that firm is financed
=
Modigliani-Miller
MM Proposition II
Leverage and the cost of equity
RL
Expected return on
leveraged equity
D
=
RU
+
( RU RD )
Expected return on
unleveraged equity
Case 1:
rWACC=15%
Case 2:
rWACC=15%
What is
happening
here?
Think of the
riskiness of
cash flows for
debtholders
Taxes
Bankruptcy or financial distress costs
Manager-shareholder conflict
Asymmetry in information
Why? Taxes!
Recall:
Corporations pay taxes
on their profits after
interest payments are
made
Interest expense
reduces the amount of
corporate taxes
TAX SHIELD BENEFIT
OF DEBT
Safeway, Inc.
/d
/
Safeways marginal corporate tax rate was 35%
Solution
VLev
Assume:
1. Constant marginal tax rate
2. Firm borrows a permanent dollar amount of debt D
That means the firm would refinance D with new debt when
it comes to maturity
3. Cost of debt = rD
VLev
W u rD u D
rD
VUnlev W u D
VL = VU + D
Debt (D)
In practice:
How is the tax shield benefit of debt
incorporated in DCF valuation?
Recall:
Free Cash Flows (FCFs) do not reflect any effect of
the choice of financing
Free Cash Flow EBIT u (1 - W c )
Depreciation
Increases in Net Working Capital
Capital expenditures
rwacc
E
D
rE
rD (1 W )
E D
E D
rwacc
E
D
rE
rD (1 W c )
E D
E D
E
D
D
rE
rD
rDW c
E D
E D
E D
Pretax WACC
Reduction Due
to Interest Tax Shield
PictureofWACCwithtaxes
Taxes matter:
Capital structure can affect firm value
Increase in debt Less taxes (lower WACC) Higher firm value
Remark: No cost of bankruptcy here
LimitstotheTaxBenefitofDebt
Toreceivethefulltaxbenefitsofleverage,a
firmdoesnotneedtouse100%debt
financing.However,thefirmdoesneedto
havetaxableearnings.
Thismaylimittheamountofdebtneededto
maximizethetaxshield.
TaxSavingswithDifferentAmountsofLeverage
Withnoleverage,thefirmreceivesnotaxbenefit.
Withhighleverage,thefirmsaves$350intaxes.
Withexcessleverage,thefirmhasanetoperatinglossand
thereisnoincreaseinthetaxsavings.
DebttoValueRatio[D/(E+D)]forSelectIndustries
InterestPaymentsasaPercentageofEBITandPercentageof
FirmswithNegativePretaxIncome,S&P50019752011
Source: Compustat.