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Finance I

Finance I. November 21. Topics covered. Last class: MM without taxes This class: MM with corporate taxes. The MM Propositions I & II (No Taxes). Proposition I Firm value is not affected by leverage Proposition II Leverage increases the risk and return to stockholders. B. S.

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Finance I

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  1. Finance I November 21 QDai for FEUNL

  2. Topics covered • Last class: MM without taxes • This class: MM with corporate taxes QDai for FEUNL

  3. The MM Propositions I & II (No Taxes) • Proposition I • Firm value is not affected by leverage • Proposition II • Leverage increases the risk and return to stockholders QDai for FEUNL

  4. B S MM Proposition II with No Corporate Taxes Cost of capital: r (%) r0 rB rB Debt-to-equity Ratio QDai for FEUNL

  5. The MM Proposition I (Corp. Taxes) • Shareholders receive Bondholders receive • The total cashflow to all the stakeholders is • The present value of the stream of cashflow is QDai for FEUNL

  6. The MM Proposition II (Corp. Taxes) Start with M&M Proposition I with taxes: The balancen sheet of a levered firm can be written as QDai for FEUNL

  7. The MM Proposition II (Corp. Taxes) The cash flows from each side of the balance sheet must equal QDai for FEUNL

  8. The MM Propositions I & II(with Taxes) • Proposition I (with Corporate Taxes) • Firm value increases with leverage • Proposition II (with Corporate Taxes) • Some of the increase in equity risk and return is offset by interest tax shield QDai for FEUNL

  9. The Effect of Financial Leverage on the Cost of Debt and Equity Capital with Corporate Taxes Cost of capital: r(%) r0 rB Debt-to-equityratio (B/S) QDai for FEUNL

  10. Total Cash Flow to Investors Under Each Capital Structure with Corp. Taxes All-EquityRecession Expected Expansion EBIT $1,000 $2,000 $3,000 Interest EBT Taxes (Tc = 35%) Total Cash Flow to S/H LeveredRecession Expected Expansion EBIT $1,000 $2,000 $3,000 Interest ($800 @ 8% ) EBT Taxes (Tc = 35%) Total Cash Flow (to both S/H & B/H): EBIT(1-Tc)+TCrBB QDai for FEUNL

  11. Tax effect of debt • In a world without taxes • When there are corporate taxes • With taxes, the sum of the debt plus the equity of the levered firm is QDai for FEUNL

  12. Total Cash Flow to Investors All-equity firm Levered firm QDai for FEUNL

  13. One question to ask Is it so that firms should then choose 100% debt in order to maximize the tax shield for the firm? In the next class, we will introduce a limit to debt: financial distress QDai for FEUNL

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