AFM274 Chapter Notes - Chapter 18: Tax Shield, Capital Structure

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lemonbeetle804

13 Aug 2018

School

University of Waterloo

Department

Accounting & Financial Management

Course

AFM274

Professor

Tu Nguyen

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Document Summary

Interest tax shield: the gain to investors from the tax deductibility of interest payments. Interest tax shield = corporate tax rate * interest payments. Mm prop i: v l = v u + pv(interest tax shield) Mm prop 1 with personal taxes: v l = v u + (t * * d) for constant debt. Value of the interest tax shield of permanent debt: pv(interest tax. Effective after tax cost of debt: r * (1 t c) * d. Effective after-tax borrowing rate: r(1 t c) After-tax wacc: r w a c c = e/(e+d) * r e + d/(e+d) * r d * (1 - t c) Leveraged recap: when securities are fairly priced, the original shareholders of a firm capture the full benefit of the interest tax shield from a n increase in leverage. Effective tax advantage of debt: t * = 1 (1 t c)(1 t e)/(1 t i)

Related Questions

F2 Q19-20

19.

You are working on a big new idea for your firm. You have projected an EBIT of $5 million starting next year (t = 1) with a growth rate of 3.50% over the foreseeable future thereafter. This endeavor will require a substantial investment and you will have to convince investors to provide you the capital to do so. Your firm will consider all types of financing options, but the first critical step in your analysis is figuring out the present value of the cash flows of the new business. Your research has revealed the following information: similar businesses have a beta asset of 2.00, the risk-free rate is 2.00% and the expected market risk premium (the average difference between the market return and the risk-free rate) is 3.50%. The corporate tax rate is 35% and interest payments on debt are tax deductible. You are tasked to figure out the value of the business under various financing alternatives, including long-term loan/debt. You have considered a loan of $25 million in perpetuity at an interest rate of 4%. Realizing that the chances of bankruptcy are negligible with this amount of ongoing debt on your balance sheet, and the riskiness of the tax shield of debt is the same as the riskiness of debt, you decide to take on $25 million of debt in perpetuity. Given this decision, you want to consider the Multiples Approach to Valuation as a double-check for your detailed Discounted Cash Flow (DCF) Based analyses. Fortunately, there have been several market transactions in this business environment using various capital structures, but you want to choose the most optimal multiple to use given your decision to use a specific capital structure. The best multiple to use will be:

a. P/E Multiple.

b. Either one is suitable for your situation.

c. EBITDA Multiple.

d. Neither one is suitable for your situation.

20.

You are working on a big new idea for your firm. You have projected an EBIT of $5 million starting next year (t = 1) with a growth rate of 3.50% over the foreseeable future thereafter. This endeavor will require a substantial investment and you will have to convince investors to provide you the capital to do so. Your firm will consider all types of financing options, but the first critical step in your analysis is figuring out the present value of the cash flows of the new business. Your research has revealed the following information: similar businesses have a beta asset of 2.00, the risk-free rate is 2.00% and the expected market risk premium (the average difference between the market return and the risk-free rate) is 3.50%. The corporate tax rate is 35% and interest payments on debt are tax deductible. You are tasked to figure out the value of the business under various financing alternatives, including long-term loan/debt. You have considered a loan of $25 million in perpetuity at an interest rate of 4%. Realizing that the chances of bankruptcy are negligible with this amount of ongoing debt on your balance sheet, and the riskiness of the tax shield of debt is the same as the riskiness of debt, you decide to take on $25 million of debt in perpetuity. Congress however is seriously contemplating modifying the tax subsidy to only debt, that is, the deductibility of interest from earnings before taxes are calculated. They instead will also allow dividend payments to be tax deductible, making giving both forms of financing the same tax status. Given this information, and assuming that costs of bankruptcy are likely to be negligible, you should:

a. Change your capital structure increase the amount of equity.

b. Not worry about your capital structure and focus on the drivers of your business.

c. Keep your capital structure unchanged because all your previous analysis will remain valid.

V2 A7 Q11-20

Note: Questions 11 - 20 relate to the same "mega" problem. For convenience we have included the entire set of information in every question. For purposes of the questions that follow, assume that changes in working capital are negligible and capex and depreciation are of the same magnitude and therefore cancel each other. This is the assumption we made in most of the videos to focus on valuation effects of borrowing and taxes and to figure out the key differences between alternative valuation methods.

Q11

You are an analyst at Goldman Sachs tasked with valuing a company, Incline, Inc., a private company. You estimate that the earnings of Incline (or EBIT) will be $100,000 next year (at t = 1) and then grow at 2% for the foreseeable future. Specifically, $100,000 at t = 1 and $102,000 at t = 2, etc. Your due diligence and analysis of comparable firms in the same industry have revealed that the beta

asset in the business of Incline, Inc. is 1.50. The risk free rate is 2.50% and the expected market risk premium (the premium that the market is expected to earn over the risk free rate) is 5.00%. The balance sheet of Incline shows that it has $250,000 of debt that it plans to maintain for the foreseeable future and the interest on the debt is 5%. The corporate tax rate is 35%, interest payments on debt are tax deductible and it is reasonable to assume that the riskiness of the

tax shield is the same as the debt. You estimate that the chances that Incline, Inc. will go bankrupt in the future are negligible. Given the above information which method is the most applicable (and easiest) to use to calculate the value of Incline, Inc.?

a) Equity Valuation Method

b) Adjusted Present Value Method

c) Enterprise Value (WACC) Method

d) Multiples Method

Q12

Use the method you chose above to obtain an estimate of the value is??

Q13

The growth rate in the cash flows to equity holders for the foreseeable future will be:

What capital structure (debt-to-equity ratio) does the valuation in Q. 12 imply for Incline, Inc. today (t=0)?

Q15

What capital structure (debt-to-equity ratio) will exist at t = 1?

a) A lower D/E ratio than t = 0.

b) Cannot evaluate given the information.

c) A higher D/E ratio than t = 0.

d) The same as t = 0.

Q16

The Enterprise Valuation method cannot be applied to this situation unless:

a) The debt to equity ratio is gxed upfront and never changed.

b) The WACC is adjusted each year for the change in capital structure.

c) The return on asset is adjusted every year for the change in capital structure.

Q17

What will be the value of Incline, Inc. one year from now (at t = 1)??

Q18

What is the return on equity to shareholders of Incline, Inc. from t = 0 to t = 1???

Q19

What is the weighted average cost of capital (WACC) of Incline, Inc. from t = 0 to t = 1 ???

Enter answer here

Q20

What will be the weighted average cost of capital (WACC) of Incline, Inc. one year from from t = 1 to t = 2?

F1 Q19-Q20

Please show workings/give explanations

Note: Questions 11 â 20 are based on the same mega problem. For convenience we have included the entire set of information in every question. For purposes of the questions that follow, assume that changes in working capital are negligible and capex and depreciation are of the same magnitude and therefore cancel each other. This is the assumption we made in most of the videos to focus on valuation effects of borrowing and taxes and to figure out the key differences between alternative valuation methods.

Q19) You are planning on opening a consulting firm. You have projected an EBIT of $2 million starting next year (t = 1) with a growth rate of 3% over the foreseeable future thereafter. This endeavor will require a substantial investment and you will have to convince investors to provide you the capital to do so. You will invest some of your own money, convincing other investors will of course be useful for your valuing your own investment decision. A critical piece of your analysis is figuring out the present value of the cash flows of the business. Your research has revealed the following information: similar consulting businesses equity has an average beta of 2.40 and the average debt-to-equity ratio in this industry is close to zero. The risk-free rate is 3.20% and the expected market risk premium (the average difference between the market return and the risk-free rate) is 4.50%. The corporate tax rate is 35% and interest payments on debt are tax deductible. Soon thereafter your hearing about your new business, your bank is willing to extend you long-term loan/debt in perpetuity of $3.50M as long as you can pay an interest rate of 8%. Realizing that the chances of bankruptcy are negligible with this amount of ongoing debt on your balance sheet, and the riskiness of the tax shield of debt is the same as the riskiness of debt, you decide to take on $3.50M of debt in perpetuity. Given this decision, you want to consider the Multiples Approach to Valuation as a double-check for your detailed Discounted Cash Flow (DCF) based analyses. Fortunately, there have been several market transactions in this business environment, but you want to choose the most optimal multiple to use given your decision to use a capital structure that is different from the competition where virtually no debt is used. The best multiple to use will be:

a) Either P/E or EBITDA multiple is suitable for your situation.

b) Neither P/E nor EBITDA multiple is suitable for your situation.

c) EBITDA multiple.

d) P/E multiple.

Q20) You are planning on opening a consulting firm. You have projected an EBIT of $2 million starting next year (t = 1) with a growth rate of 3% over the foreseeable future thereafter. This endeavor will require a substantial investment and you will have to convince investors to provide you the capital to do so. You will invest some of your own money, convincing other investors will of course be useful for your valuing your own investment decision. A critical piece of your analysis is figuring out the present value of the cash flows of the business. Your research has revealed the following information: similar consulting businesses equity has an average beta of 2.40 and the average debt-to-equity ratio in this industry is close to zero. The risk-free rate is 3.20% and the expected market risk premium (the average difference between the market return and the risk-free rate) is 4.50%. The corporate tax rate is 35% and interest payments on debt are tax deductible. Soon thereafter your hearing about your new business, your bank is willing to extend you long-term loan/debt in perpetuity of $3.50M as long as you can pay an interest rate of 8%. Realizing that the chances of bankruptcy are negligible with this amount of ongoing debt on your balance sheet, and the riskiness of the tax shield of debt is the same as the riskiness of debt, you decide to take on $3.50M of debt in perpetuity.The government however is seriously contemplating removing the tax subsidy to debt, that is, the deductibility of interest but not dividends from earnings before taxes are calculated. Given this information, and assuming that costs of bankruptcy are likely to be negligible, you should:

a) Change your capital structure and lower your debt.

b) Not worry about your capital structure and focus on the value drivers of your business.

c) Keep your capital structure unchanged because all your previous analysis will remain valid.

AFM274 Chapter Notes - Chapter 18: Tax Shield, Capital Structure

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