Capital Structure IIReview questionAnswerMM II without taxesSlide 5Slide 6MM Proposition II no taxWeighted average cost of capitalNow with taxes.MM I with taxesWhy?Short derivationMM II (with taxes)Effect of tax shieldMM II and WACCWACC not equal to r0. Why?WACC declines with leverage.rS increases with leverage. Why?A little derivationSlide 20Slide 21Slide 22Slide 23More answerSlide 25Capital Structure IICorporate income taxesReview questionDescribe the two basic capital budgeting decisions.AnswerProject acceptance: each project is independent of others. Each is accepted or rejected. Choice between mutually exclusive projects. Of two or more projects, only one can be undertaken.MM II without taxesFacts and derivation.Fact 1: Leverage does not change market valueFact 2: All cash flows are accounted for.BSSLUBrSrSrBLSU0MM ICash BrSrBSrBLSL )(0BrBSrSrBLLS )(0BrBSrSrBLLS )(0BrrSrSrBLLS)(00LBSSBrrrr )(00MM Proposition II no taxDebt-to-equityratio (B/S)Cost of capital: r(%).r0rSrWACCrBLBSSBrrrr )(00Weighted average cost of capitalThe cost to the firm of undertaking a project.Here independent of leverage …because leverage doesn’t matter.Now with taxes.No threat of bankruptcy.Corporate taxes, not personal.Government gets a piece of the pie.A smaller piece if the firm has debt.MM I with taxesVU = market value of the unlevered firmVL = market value of the levered firmB = market value of bondsTC = corporate tax rateVL = VU + TC BWhy?Why isn’t the bond rate in the formula?The bond is a perpetuity.Market rB is the right discount rate for the perpetuity.Short derivationEach year the tax shield is rBTCBValue of tax shield isrBTCB/rB = TCBMM II (with taxes)Corporate taxes, not personalrB = interest raterS = return on equityr0 = return on unlevered equity B = value of debtSL = value of levered equity Previously, without taxes rS = r0 + (B/SL)(r0 - rB)Effect of tax shieldIncrease of equity risk is partly offset by the tax shieldrS = r0 + (1-TC)(r0 - rB)(B/SL) Leverage raises the required return less because of the tax shield.MM II and WACCDebt-to-equityratio (B/S)Cost of capital: r(%).r0rSrB..rWACC.WACC not equal to r0. Why?r0 is the return on unlevered equity.WACC is for risk like that of the physical asset of the firm.Adding debt reduces risk of the asset of the firm.Adding debt reduces WACC.The levered firm is in a lower risk category.WACC declines with leverage.Why?Because the project is producing bigger interest tax shields,and the tax shields are a relatively safe asset.rS increases with leverage. Why?Leverage raises risk …  and is only partly offset by the tax shield.A little derivationAgain. Market value equation.Cash flow equation.The latter is a version of WACC.BTSBSCULBrTSrBrSrBCUBLS0MM ICash BrBrTSrSrBBCULS0BrBrTBTBSrSrBBCCLLS )(0Rewrite cashSub in MM IBrBrTBTBSrSrBBCCLLS )(0)1()1(00CBCLLSTBrTBrSrSr))(1(00 BCLSrrTSBrr CopyingCombinetermsFinallyReview questionDoes a good project have IRR greater than the hurdle rate, or less?AnswerIRR is the discount rate that makes NPV(IRR) = 0.The hurdle rate is the market rate for the risk-class.Investing means cash flows are first negative, then positive.Financing (in this context) means cash flows are first positive, then negative.More answerOther sign patterns, IRR is not useful.Investing, a good project has IRR > hurdle rate.Financing, a good project has hurdle rate >