BUSFIN 4211: 5.3: Capital Structure: WACC with Taxes

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Recall: Perfect capital markets involve

fair pricing of securities, no taxes or transaction costs, and no effect of capital structure on cash flows

firm value and cash flows, and therefore the overall (or weighted average) cost of capital, are unaffected by leverage (This is Pre Tax WACC as it doesn’t account for taxes)

Recall: Unlevered (No debt. Equity)

We can estimate equity cost of capital with the CAPM equation

Recall: Levered Firm: (Debt AND Equity)

Expected return on portfolio containing firm’s equity and debt

Interest expenses are

tax deductible, so they reduce the firm’s tax bill.

AI: Debt investors lend money, company pays them interest expense as a thank you.

Cash Flows

• Financing with debt is beneficial for firms, because it reduces the share of cash flows that is paid to the government, which increases the amount of money that the firm can pay to investors

• In other words, by increasing cash flows to investors, leverage increases the value of the firm

Total cash flow WITH leverage is

greater than WITHOUT leverage

Interest Tax Shield is

the additional amount the firm can pay to investors by saving taxes it would have paid

without leverage.

The value of the firm is the

present value of cash flows to investors

MM1 with Taxes:

The total value of the levered firm exceeds the value of the firm without

leverage due to the present value of the tax savings from debt

The appropriate discount rate for valuing the interest tax shield should

correspond to the risk of the cash flows

What causes the tax shield to vary over time? Equivalently, what affects its risk?

• There is a risk the company will default, or will not be able to make interest payments

• The company could change its debt policy after its current debt matures (AI: How much it wants to borrow)

• The tax code could change, increasing or decreasing the tax shield for each dollar of interest

Simplest case: Single debt issuance with plan to repay at maturity

• In that case, the interest tax shield’s discount rate should be the yield on the debt (=the cost of debt)

• This is the rate that sets the present value of cash flows to debtholders equal to the value of the debt!

Permanent debt

is a more realistic assumption.

Assume the firm plans to keep its $ amount of debt constant forever. Then, the market value of debt is the PV of interest payments

t’s unrealistic to assume the firm will retire all its outstanding debt, passing up the opportunity to refinance and continue saving on taxes in the future

Ways to implement a permanent debt:

1) Issue a consol bond (AI: Bond never expires or paid back)

2) refinance every maturity by issuing new debt in the

same amount and using the proceeds to repay the outstanding debt (AI: Pay old, get or continue new)

We do NOT incorporate this benefit of debt in

capital budgeting,

Pre-Tax Debt Cost of Capital: Measure with the yield on outstanding debt

• Interest rate the firm would have to pay to refinance its existing debt (i.e., issuing bonds)

• This is NOT the same as the coupon rate the firm pays on outstanding debt! (AI: Past)

• Yield to maturity on outstanding debt reflects the rate the firm would pay if it were to issue

new debt today, as it reflects the market’s perception of credit risk and time value of money

Coupon rate

reflects the interest rate paid on previously issued debt

Yield

reflects the interest rate currently demanded by the market

We can view the interest tax shield as

decreasing the firm’s cost of capital

With taxes, cash flow from firm are split into three pieces:

• Equity

• Debt

• Taxes

Debt interest payments are tax deductible!

• Dividend payments are (shareholders, equity holders)

not

by reducing tax payments, we can

increase the combined size of the debt & equity

slices. The size of the pie increases as the fraction of debt to equity increases

Why don’t firms increase leverage to 100% to maximize firm value?

MM Deviation Lectures: Costs of financial distress make excessive leverage costly!