Page 196 - DMGT207_MANAGEMENT_OF_FINANCES

Unit 8: Capital Structure Decision

where Notes
V is the value of a levered firm.
y
V is the value of an unlevered firm.
x
TD is the tax rate (T) × the value of debt (D)

The term TD assumes debt is perpetual
This means that there are advantages for firms to be levered, since corporations can deduct
interest payments. Therefore leverage lowers tax payments. Dividend payments are non-
deductible.
Proposition II:
r = r + D/E (r – r )(1 – T)
E 0 0 D
where
r is the required rate of return on equity, or cost of equity.
E
r is the cost of capital for an all equity firm.
0
r is the required rate of return on borrowings, or cost of debt.
D
D/E is the debt-to-equity ratio.
T is the tax rate.
The same relationship as earlier described stating that the cost of equity rises with leverage,
because the risk to equity rises, still holds. The formula however has implications for the
difference with the WACC. Their second attempt on capital structure included taxes has identified
that as the level of gearing increases by replacing equity with cheap debt the level of the WACC
drops and an optimal capital structure does indeed exist at a point where debt is 100%.
The following assumptions are made in the propositions with taxes:

1. Corporations are taxed at the rate T on earnings after interest,
2. No transaction costs exist, and
3. Individuals and corporations borrow at the same rate
Illustration 5: Assume two firms firm U and L which are identical in terms of their asset and
operations. Firm U is unlevered firm (all equity) with operating earning (EBIT) of 1000 with
the marginal tax rate is 40%. Firm L is a levered firm that has issued 2000 perpetual bonds with
an interest rate is 10%. Calculate the tax impact of both the companies.
Solution:
Firm U Firm L

EBIT 1000 1000
Interest exp. 0 200
EBT 1000 800

Taxes 400 320
Net income 600 480

LOVELY PROFESSIONAL UNIVERSITY 191