Page 101 - DCOM504_SECURITY_ANALYSIS_AND_PORTFOLIO_MANAGEMENT

Security Analysis and Portfolio Management

Notes However, the assumptions behind Proposition I do not all hold. One of the more unrealistic
assumption is that of no taxes. Since the firm benefits from the tax deduction associated with
interest paid on the debt, the value of the levered firm becomes:
V = V + t D
L U c
where t = marginal corporate tax rate.
c
When considering the effect of taxes on firm value, it is worthwhile to consider taxes from a
potential investors point of view. For equity investors, the firm first must pay taxes at the
corporate tax rate, t , then investor must pay taxes at the individual equity holder tax rate, t .
c e
Then for debt holders.
After-tax income = (debt income) (1 – t )
d
For equity holders,
After-tax income = (equity income) (1 – t ) (1 – t )
c e
The relative advantage (if any) of equity to debt can be expressed as:
Relative Advantage (R ) = (1 – t ) (1 – t )/(1 – t )
A c e d
R > 1 signifies a relative advantage for equity financing.
A
R < 1 signifies a relative advantage for debt financing.
A
One can define T as the net advantage of debt:
T = 1 – R
A
For T positive, there is a net advantage from using debt; for T negative there is net disadvantage.
Empirical evidence suggests that T is small, in equilibrium T = 0. This is known as Miller’s
equilibrium and implies that the capital structure does not affect enterprise value (though it can
affect equity value, even if T = 0).

3.5 Calculating the Cost of Capital

Note that the return on assets, r , sometimes is referred to as r the unlevered return.
a u
Gordon Dividend Model
1
P = Div /(r – g)
0 e
where, P = Current stock price,
0
Div = Dividend paid out one year from now
1
r = Return of equity
e
g = Dividend growth rate
1
Then: r = (Div /P ) + g
e 0
Capital Asset Pricing Model
The security market line is used to calculate the expected return on equity.
r = r + (r – r )
e f e m f
where, r = Risk-free rate,
f

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