Unlevered firm: all-equity, no debt

Levered firm: with debt

EPS (Earnings per share) = Net income / Number of shares outstanding

ROE (Return on equity) = Net income / Total equity
ROA (Return on asset) = Net income / Total assets

Break-even point is the EBIT that makes EPS (current capital structure, no debt) =
EPS (proposed capital structure, with debt)
EBIT/number of shares outstanding under current CS
= (EBIT – Interest) / number of shares outstanding under proposed CS

 EBIT = ? : this is the break-even EBIT

If we expect EBIT less than the break-even EBIT (bad time), should not use debt
(leverage).
If we expect EBIT greater than the break-even EBIT (good time), should use debt
(leverage).

M&M proposition I is about firm value

M&M proposition II is about cost of capital (cost of levered equity RS and cost of
capital RWACC)

Slide 17: Value of a levered firm (with taxes)

VL = VU + BTc
where: VU = EBIT(1-Tc) / R0
Proof:
With taxes, interest expense on debt is tax deductible. Therefore, firm value
increases when firm uses debt.
The tax saving is: BRBTc : interest tax shield
Assume perpetual cash flow. The present value of interest tax shield: BR BTc / RB =
BTc
Conclusion: With taxes, the value of a levered firm increases by the present value
of interest tax shield. This is the M&M proposition I (with taxes).
No taxes:
Cost of capital (WACC) in a levered firm:

where RS (cost of equity in a levered firm) is calculated using formula

in slide 14

Cost of capital (WACC) in an all-equity firm:

RWACC = R0

With taxes:
Cost of capital (WACC) in a levered firm:

where RS (cost of equity in a levered firm) is calculated using formula in

slide 17