FINAL EXAM CHAPTERS: 14, 15, 16, 17, 18, 20, 21, 23, 24, 25, 26, 27, 28, 30
MM Propositions:
,- MM Proposition I (No Taxes): The market value of any firm is independent of its
capital structure.
- MM Proposition II (No Taxes): The cost of equity is positively related to the firm's
debt-equity ratio.
- MM Proposition I (With Taxes): The value of the firm increases as the amount of
debt increases, due to the interest tax shield.
- MM Proposition II (With Taxes): The cost of equity rises with leverage, but is
partially offset by the tax shield benefit.
- No Taxes: MM Proposition I states that a firm's market value is independent of
its capital structure, while Proposition II says the cost of equity is positively
related to the firm's debt-equity ratio.
- With Taxes: MM Proposition I states that a firm's value increases with debt due
to the interest tax shield, while Proposition II says the cost of equity rises with
leverage but is partially offset by the tax shield benefit.
,Chapter 14:
, Chapter 15: Debt and Taxes
Learning Objectives
- Explain the effect of interest payments on cash flows to investors.
- Calculate the interest tax shield, given the corporate tax rate and interest payments.
- Calculate the value of a levered firm.
- Calculate the weighted average cost of capital with corporate taxes.
- Describe the effect of personal taxes on the corporate tax benefits of leverage.
- Describe what constitutes optimal leverage in a world with taxes
- Analyze how optimal capital structure changes with the lifecycle of the firm
Taxes and Firm Value
- In most countries/lines of business corporations pay taxes on their profits
→ What is the consequence of taxation for firm value?
To answer, we will relax one of the assumptions of the Modigliani and Miller perfect capital market:
Investors and firms can trade the same set of securities at competitive market prices equal to the present
value of their future cash flows.
There are no taxes, transaction costs, or issuance costs associated with security trading.
A firm’s financing decisions do not change the cash flows generated by its investments, nor do they reveal
new information about them.
In this case, it is not only important what assumption has been removed, but also what
assumptions remain.
Under the “remaining assumptions” of MM, what is the consequence of taxation for firm value?
Question: This slice is fundamentally different from :
-the debt slice
-the equity slice
How is it different?
A firm is run to maximize the profits for its capital providers
– The government never puts money into the firm
• When the government puts its hands in the firm’s pockets,
– It takes a slice of profits
– This reduces (with fixed firm investment) the value of the firm
• So, the management of the firm (operating on behalf of the capital providers) will do everything to
reduce taxation of its profits
MM Propositions:
,- MM Proposition I (No Taxes): The market value of any firm is independent of its
capital structure.
- MM Proposition II (No Taxes): The cost of equity is positively related to the firm's
debt-equity ratio.
- MM Proposition I (With Taxes): The value of the firm increases as the amount of
debt increases, due to the interest tax shield.
- MM Proposition II (With Taxes): The cost of equity rises with leverage, but is
partially offset by the tax shield benefit.
- No Taxes: MM Proposition I states that a firm's market value is independent of
its capital structure, while Proposition II says the cost of equity is positively
related to the firm's debt-equity ratio.
- With Taxes: MM Proposition I states that a firm's value increases with debt due
to the interest tax shield, while Proposition II says the cost of equity rises with
leverage but is partially offset by the tax shield benefit.
,Chapter 14:
, Chapter 15: Debt and Taxes
Learning Objectives
- Explain the effect of interest payments on cash flows to investors.
- Calculate the interest tax shield, given the corporate tax rate and interest payments.
- Calculate the value of a levered firm.
- Calculate the weighted average cost of capital with corporate taxes.
- Describe the effect of personal taxes on the corporate tax benefits of leverage.
- Describe what constitutes optimal leverage in a world with taxes
- Analyze how optimal capital structure changes with the lifecycle of the firm
Taxes and Firm Value
- In most countries/lines of business corporations pay taxes on their profits
→ What is the consequence of taxation for firm value?
To answer, we will relax one of the assumptions of the Modigliani and Miller perfect capital market:
Investors and firms can trade the same set of securities at competitive market prices equal to the present
value of their future cash flows.
There are no taxes, transaction costs, or issuance costs associated with security trading.
A firm’s financing decisions do not change the cash flows generated by its investments, nor do they reveal
new information about them.
In this case, it is not only important what assumption has been removed, but also what
assumptions remain.
Under the “remaining assumptions” of MM, what is the consequence of taxation for firm value?
Question: This slice is fundamentally different from :
-the debt slice
-the equity slice
How is it different?
A firm is run to maximize the profits for its capital providers
– The government never puts money into the firm
• When the government puts its hands in the firm’s pockets,
– It takes a slice of profits
– This reduces (with fixed firm investment) the value of the firm
• So, the management of the firm (operating on behalf of the capital providers) will do everything to
reduce taxation of its profits
