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CHAPT POLICY
LEARNING OBJECTIVES
2
IRRELEVANCE OF
CAPITAL STRUCTURE:
NOI APPROACH AND THE MM
HYPOTHESIS
WITHOUT TAXES
MM Approach Without
10
Tax: Proposition I
MMs Proposition I is
that, for firms in the same
risk class, the total market
value is independent of
the debt-equity mix and is
given by capitalizing the
expected net operating
income by the
capitalization rate (i.e.,
the opportunity cost of
capital) appropriate to
that risk class.
MMs Proposition I: Key
11 Assumptions
Perfect capital markets
Homogeneous risk classes
Risk
No taxes
Full payout
The cost of capital under
12 MM proposition I
Net Operating Income (NOI)
13
Approach
According to NOI approach the value of the firm
and the weighted average cost of capital are
independent of the firms capital structure. In the
absence of taxes, an individual holding all the debt
and equity securities will receive the same cash
flows regardless of the capital structure and
therefore, value of the company is the same.
MMs approach is a net operating income
approach.
Arbitrage Process
14
RELEVANCE OF CAPITAL
STRUCTURE:
THE MM HYPOTHESIS UNDER
CORPORATE TAXES
19
Suppose two firms L and U are identical in all respects except that firm L
is levered and firm U is unlevered. Firm U is an all-equity financed firm
while firm L employs equity and Rs 5,000 debt at 10 per cent rate of
interest. Both firms have an expected earning before interest and taxes (or
net operating income) of Rs 2,500, pay corporate tax at 50 per cent and
distribute 100 per cent earnings as dividends to shareholders.
21
You may notice that the total income after corporate tax is Rs 1,250 for the
unlevered firm U and Rs 1,500 for the levered firm L. Thus, the levered
firm Ls investors are ahead of the unlevered firm Us investors by Rs 250.
You may also note that the tax liability of the levered firm L is Rs 250 less
than the tax liability of the unlevered firm U. For firm L the tax savings
has occurred on account of payment of interest to debt holders. Hence, this
amount is the interest tax shield or tax advantage of debt of firm L: 0.5
(0.10 5,000) = 0.5 500 = Rs 250. Thus,
Value of Interest Tax
22 Shield
Interest tax shield is a cash inflow to the firm and therefore, it is
valuable.
The cash flows arising on account of interest tax shield are less
risky than the firms operating income that is subject to business
risk. Interest tax shield depends on the corporate tax rate and the
firms ability to earn enough profit to cover the interest payments.
The corporate tax rates do not change very frequently.
Under the assumption of permanent debt, the present value of the
present value of interest tax shield can be determined as follows:
Value of the Levered
23 Firm
Value of the levered firm
24
Implications of the MM
25 Hypothesis with
Corporate Taxes
The MMs tax-corrected view suggests that, because of the
tax deductibility of interest charges, a firm can increase its
value with leverage. Thus, the optimum capital structure is
reached when the firm employs almost 100 per cent debt.
AND
Companies everywhere pay corporate tax on their earnings. Hence,
PERSONAL TAXES
the earnings available to investors are reduced by the corporate tax.
Further, investors are required to pay personal taxes on the income
earned by them.
Therefore, from investors point of view, the effect of taxes will
include both corporate and personal taxes.
A firm should thus aim at minimizing the total taxes (both
corporate and personal) to investors while deciding about
borrowing.
How do personal income taxes change investors return and value?
It depends on the corporate tax rate and the difference in the
personal income tax rates of investors.
Limits to Borrowings
28
The attractiveness of borrowing depends on corporate tax rate, personal tax rate
on interest income and personal tax rate on equity income.
The advantage of borrowing reduces when corporate tax rate decreases, or when
the personal tax rate on interest income increases, or when the personal tax rate
on equity income decreases.
A firm will stop borrowing when (1 Tpd) becomes equal to (1 Tpe) (1 T).
Thus, the net tax advantage of debt or the interest tax shield after personal taxes
is given by the following:
Corporate and Personal
Tax Rates in India
29
Combined Income of
Investors: Unequal
Personal Tax Rates
Millers Model
31
It is now widely accepted that the effect of personal taxes is to lower the
estimate of the interest tax shield.
Millers Model
32
With more and more debt, the costs of financial distress increases and
therefore, the tax benefit shrinks. The optimum point is reached when
the marginal present values of the tax benefit and the financial distress
cost are equal. The value of the firm is maximum at this point.
Agency Costs
39
ShareholdersManagers conflict
The firm should employ debt to the point where the marginal
benefits and costs are equal.
This will be the point of maximum value of the firm and
minimum weighted average cost of capital.
The difficulty with the valuation framework is that managers
find it difficult to put into practice.
The most desirable capital structure is the one that creates the
maximum value.
Cash Flow Analysis
48