ACTSC372 Chapter Notes - Chapter 18: Cash Flow, Capital Structure, Weighted Arithmetic Mean
20 Jun 2019
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The m&m models assume that the company has a fixed dollar amount of debt in perpetuity. M&m with taxes shows that the value of the levered company is. If we assume a fixed debt-to-value ratio, then debt and the tax shields grow in direct proportion to the value of the company. To derive prop 2 we don"t need to make an explicit assumption about growth. Lhs is the portfolio on equity and debt of levered firm. Think of each side as two separate portfolios. Rhs is the portfolio of equity of the unlevered firm and the tax shields. Thus these two portfolios are the same. If interest tax shields have the same variability as the company"s fcf, then it is logical discount the interest tax shields with k_u => k_ts = k_u. Thus, more solving shows: k_u = (k_e)(e/v) + (k_d)(d/v, note how the required return of unlevered sh is equal to the no tax wacc.
