Introduction to Finance
Introduction to Finance UGBA 103
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This 6 page Class Notes was uploaded by Melba Champlin on Thursday October 22, 2015. The Class Notes belongs to UGBA 103 at University of California - Berkeley taught by J. Berk in Fall. Since its upload, it has received 40 views. For similar materials see /class/226751/ugba-103-university-of-california-berkeley in Business Administration at University of California - Berkeley.
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Date Created: 10/22/15
ask me Modigliazm MilletI 0017 Orata tw I When the level of debt is constant in perpetuity VL VU TCD I The value of a levered firm equals the value of the unlevered firm plus the value of the tax shield Example 7 I Outages Clothes is currently unlevered It is considering a stock repurchase nanced b 200000 of debt FCF prior to the restructurin is expecte to be 150000 in perpetuity Cost of debt is 1 and the cost of e uity for unlevered rms in the same industry is 20 Vllhat happens to the value of Outages when the restructuring is announced Assuming that Outages has 100000 shares outstanding what happens to the price per share M 119V II w th C orporata Tm I What happens to the return on equity when there is a tax shield I Try guessing I Let s see M Grieg1W 39 39 M 111 II W 0th C orporata TM I What happens to the return on equity when there is a tax shield I Try guessing ILet s see u Fanw I What is the return on equity to an unlevered firm in the constant perpetuity model Level60L Farm1x I What is the return on equity to an levered firm in the constant perpetuity model EBIT RDD1 1 R E E I Substituting the expression from the last slide glVESiR VURU TC E E 7 EBIT1 T U VU ISo EBIT1 Tc 2 VURU LWWQOL Filmw WW I Substituting for VU from MM I with taxes gives VL TCDRU RDD1 Tc RE E I Finally the value of the firm to the investors is sum of debt and equity ie EDE Lewenwaawvoon MdeJ E D TCDRU RDD1 Tc RE E D RU ERU RD1 Tc OutagesCW CowtuuuaL I What is the return on equity before and after the refinancing Miller II WWIcorporate deli D RE 2 RU Eat RD1 T I The required return on equity is a linear function of the firm39s debt to equity ratio and tax rate I The higher the debt to equity ratio the higher the return on equity I The higher the tax rate the lower the return on equity in WACC wiltmi I When their are corporate taxes we define the WACC as Rwacc D D EDREEDRDTED RDTC WACC MadWu Neva60L CothfCapwaL I Recall that with no taxes the WACC equaled the unlevered cost of capital I We can derive the relation between the WACC and the unlevered cost of capital with taxes using the expression we derived for the cost of equity D RE 2 RU EMU RD1 TC 13 WACC WWUWWWL COW OfCathal I Multiplying by E and rearranging ERE RUE 7 7 TC ERE DRD RUE i DRU i Rpm DRU ERU DRU 7 DRUTC ngpTC I Dividing by E D the value of the levered firm and rearranging WACC MadWu Neva60L CothfCapwaL I 80 E U U EDRU EDRU ED D RU 1 m2 I That is the WACC of a levered firm is lower than the WACC of an unlevered firm that is the unlevered return RU Tc Rwacc E D D R 71 773 Tc ED EED D ED D E D D R R 7 RTC ED UED U ED U m PWWTW I The personal tax on equity and debt is different I Dividend and capital gain taxes are not the same as taxes on interest income I Capital gains can be deferred mm WW I Currently the dividend andcapital gains tax is 15 while the tax on interest income is 35 The corporate tax rate is 35 I After ALL tax has been paid 1 paid to I debt holders turns into 1O35 I equity holders turns into 1O351O15 I So the actual advantage of debt is only 15 I Of course it could be lower for a non dividend paying stocllt because you can delay capital gains 17 I Debt holders pay 1T1 I Equity holders pay 1TC 1Te I So the effective tax advantage of debt is the tax rate T that sets the after tax cash ows equal 1 T1 1 Tc1 Te 3950 1 TC1 T 1 Ti Earnings Before Interest and Taxes 1 Paid as Interest Paid as DividendCapital Gain Corporate Tax TC Pretax Investor 1 Cash Flows 1 TC Tax on Interest Tax on Equity Income 7 Income 7 AfterTax T Investor 1 TC Te to Debt Holders Cash Flows to Equity Holders DOFWm Sh elda W 6000 Quarterly 1 Year Moving Average InterestEBIT OJ 0 ED 000 1 I I 1 1975 1980 1985 1990 1995 2000 2005 Year Why Do Fawn5x NatlW WOW I There must be something counterbalancing taxes I Next lecture Next Lecture I Topic I Bankruptcy Costs I Other Imperfections I Reading I Chapter 16
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