AFM373 Lecture Notes - Lecture 11: Net Present Value, Tax Shield, Investment Policy
28 Jun 2018
School
Department
Course
Professor
Class 15 - Feb 28th
February 28, 2018 11:38 AM
AFM 373 Page 1
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No tax shields ○
No tax•
No Risk of bankrupt ○
No cause of financial distress
•
Investment policy is fixed
•
Original assumption
First case
More debt will eventually increase cost of debt
even if we assume it is default free (no cause of
financial distress)
•
More debt will also eventually increase cost of
equity
•
WACC doesn't change because value of the
firm doesn't change.
•
So it doesn't matter if the percentage of D and
E is 90
-
10 or 60
-
40, the value of the whole
doesn’t change.
•
Capital structure is irrelevant to the value of the firm.
Second case
Interest tax shield•
Cost of debt will decrease (1-t) than first case.
But still increase as firm take more debt.
•
Cost of equity will increase
•
WACC will decrease because cost of debt
decreased
•
Firm value will increase because of tax shields.
•
If there are corporate tax, what would change?
Third case
More debt = more likely of financial stress
•
Cost of debt and equity will go up a little
sharply
•
WACC will decrease first due to tax benefits
and then increase due to costs of financial
distress
•
Value will increase first and the decrease like a
parabola shape.
•
As CFO of the firm, we want to maintain at the
middle point before WACC starts to increase
and value starts to decrease.
•
There is tax and cost of financial stress
D/V ratio differs by industry
e.g. 91% debt in financial services because they
borrow and lend as their service.
It's our job to understand what firm and situation
leads it to low debt or high debt.
But CEO says borrow at 5% and EPS/ROE will go up. He's right.•
As EPS/ROE go up, more debt will increase risk on equity which shareholders will demand
higher ROE which will lead to decrease in P/E
○
We still shouldn't do it firm price will go down (P/E decreases) •
Reject because IRR is lower than WACC
AFM 373 Page 2
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Document Summary
Capital structure is irrelevant to the value of the firm. More debt will eventually increase cost of debt even if we assume it is default free (no cause of financial distress) More debt will also eventually increase cost of equity. Wacc doesn"t change because value of the firm doesn"t change. So it doesn"t matter if the percentage of d and. E is 90-10 or 60-40, the value of the whole doesn"t change. Cost of debt will decrease (1-t) than first case. But still increase as firm take more debt. Wacc will decrease because cost of debt decreased. Firm value will increase because of tax shields. There is tax and cost of financial stress. More debt = more likely of financial stress. Cost of debt and equity will go up a little sharply. Wacc will decrease first due to tax benefits and then increase due to costs of financial distress. Value will increase first and the decrease like a parabola shape.
