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• FINANCIAL MANAGEMENT 2
• MODULE 2

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• Module 2
• Cost of capital –RECAP
• Capital Budgeting : Analysis of Cash Flows
• Risk analysis in Capital Budgeting

• Capital structure theories and capital budgeting for

levered firms

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• Cost of Capital : RECAP

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Cost of capital … intuitive meaning

• When investors provide a corporation with funding,
they expect the company to generate an
appropriate return on those funds.

• From the firm’s perspective, the investors expected

return is the cost of using their funds, and it is
called….. “the cost of capital”.

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Cost of capital … intuitive

meaning..contd..
• Why cost of capital is relevant from the point of
view of Capital Investment Decisions ?
• Knowing the cost of capital can help the company
determine their required return for capital
budgeting decisions
• Why ?

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Required return, cost of capital

and discount rate
• Corporation receives cash : It can either :
• Pay dividends to shareholders
• Can invest extra cash in a project , paying out the future
cash flows from the project as dividend
• Which procedure would the shareholders prefer ?
• If a shareholder can reinvest the dividend in a financial
asset with the same risk as that of the project, the
shareholders would like the alternative with the
highest expected return.

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Required return, cost of capital

and discount rate..contd..
• In other words
• the project should be undertaken only if the expected
return from it is more than that of a financial asset of
similar risk.
• The discount rate of the project should therefore be the
expected rate of return on a financial asset of
comparable risk.
• From the firm’s perspective this expected return is the
cost of capital.
• required return is from an investor (providers of
capital)point of view

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Weighted Average Cost of capital (WACC)

• It is possible to finance a firm entirely by equity.

Most firms however employ several types of long
term capital :
• Debt
• Preferred stock
• Common Equity
• All the capital components have one feature in
common :
• The investors who provided the funds expect to receive
a return on their investment.

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WACC.. Contd..
• If the firm’s only investors were common stock holders ,then
cost of capital would have been = the required rate of return
on equity

• Because of different types of capital employed, and due to

difference in their servicing obligation/risk, these different
securities have different required rates of return.

• The required rate of return on each component is the

‘component cost’ and the weighted average of such
component costs is called the WACC .

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WACC.. expression
• WACC = wd. Kd + we.Ke + wpe.Kpe
• where wd, we and wpe are the respective weights or
proportions of debt, equity and preferred equity(
market value based not book value) in the total capital
employed
• Kd, Ke and Kpe are the required rates of return by the
debt, equity and preferred equity holders.

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WACC implication
• A company says that its current WACC is 20%.

• What does this 20% Cost of Capital loosely mean?

• For every Re.1 raised by the company now, it has to pay
out(in form of dividends and interest) Re.0.20 or 20 p -
per year for ever

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Cost of Debt
• The rate of return required by the debt holders…
• Cost of debt should be ‘relevant’ or ‘marginal’ and not
the same as the ‘average’ cost of all previously issued
debt which are also called ‘historical or embedded rate’.

• This is because when the actual money will be raised

from the market historical cost will be of little
significance. The current or marginal cost will be what
will matter.

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Estimates for debt Cost

• if the company is estimated to be issuing “new” bond at par
then its coupon rate will be an estimate of the cost of debt.

• If the company has already issued bonds in the past, then the
yield to maturity on these debt issues, is the estimate of
market required rate of return on the firm’s debt. In this case,
the coupon rate will be irrelevant because the coupon rate was
approximately the rate of return that was asked by the market
when the bond was issued.

• If the firm has never issued debt in the past, then one could
also look at YTMs of bond issues of similar firms, for a
reasonable estimate of debt cost.

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Impact of tax on Debt cost

• Because interest paid on debt is tax deductible, the
effective cost of debt to the company is actually less
than the actual rate…
• the Govt. in effect bears a part of the cost by fore going a
certain amount of tax.

• The actual cost is the ‘after tax cost of debt’

• = (1-T)*Kd
• where T is the tax rate applicable for the firm.
• and Kd is the nominal cost of debt.

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Impact of tax on Debt cost..contd..

• Example : Suppose a firm borrows $1 million at 9%
interest. The corporate tax rate is 34%. What is the after
tax interest rate for this loan ?
• The total interest bill is $90,000 per year. This amount is tax
deductible.

• So this interest paid reduces the tax bill by 0.34*$90,000 =

$30,600.

• The after tax interest bill is therefore $90,000 - $30,600 =

$59,400.

• The after tax interest rate is therefore $59,400/ 1 million = 5.94%

which is again = (1-0.34)*9%

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After tax WACC

• The after tax WACC expression is thus modified as
follows :

• WACC after tax( adjusted) = wd. Kd (1-T)+ we.Ke + wpe.Kpe

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Cost of Preferred Stock

• Preferred dividends are not tax deductible. Hence no
adjustment for taxes need to be made for preferred stocks.
• The cost of preferred stock is given by,
& "#
D "$ =
%!
• Where Dps is the preferred stock dividend and pn is the net issue
price , which is the net price that the issuing firm receives after
floatation costs. ( as floatation costs of preferred stocks are higher
hence they need to be considered)

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Cost of capital for a firm

• It is also the cost of equity . It is the rate of return expected by
the equity investors in the company/project.
• More difficult to estimate the cost of equity compared to cost of debt
or preferred stock.

• Following approaches are used in practice to obtain reasonably

good estimates of rs
• CAPM approach
• Gordon Growth Model /constant growth approach
• Bond yield plus risk premium approach

• The methods are not mutually exclusive.

• In fact mostly all three are applied and then one is chosen from them
depending on the confidence the analyst has in the data used for each .

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Measuring Cost of equity..CAPM

• The generic equation for measuring cost of equity of ANY firm
is given by CAPM , as

• Re = RF + risk premium of the equity

• i.e # & = # " + ! " %&%#$ ! ! # " !

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Practice Problem 18
• A corporation has 10,000 bonds outstanding with a 6%
annual coupon rate, 8 years to maturity, a $1,000 face
value, and a $1,100 market price.
• The company’s 100,000 shares of preferred stock pays a $3
annual dividend, and sell for $30 per share.
• The company’s 500,000 shares of common stock sell for $25
per share, have a beta of 1.5, the risk free rate is 4%, and
the market return is 12%.
• Assuming a 40% tax rate, what is the company’s WACC?
• 9.8%
• module-2 -numericals.xlsx

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Measuring Cost of equity..CAPM ..contd..

• If a firm has no debt in its capital structure:
• then its risk premium consists solely of a business risk premium.

• In that case, the stock's beta should therefore reflect

the systematic risk inherent in its basic business
operations.
• With no financial leverage, the beta of the firm should
therefore be its unlevered beta, βu and should capture this
business risk only.
• Unlevered beta is also sometimes called the asset beta.
• The cost of equity of such a firm is given by,

'
#& = # " + ! " %&%#$ ! ! # " !

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What determines business risk or

unlevered beta?
• Business Risk of a firm depends on :
• Cyclicality of Revenues
• Operating Leverage

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Cyclicality of Revenues
• Highly cyclical stocks have high betas :

• because beta is nothing but the standardized covariance of the

stock’s return with the market’s return

• so stocks which are affected largely by cycles which in general

also typically affect the market should have high betas.

• Empirical evidence suggests that retailers and automotive firms

fluctuate with the business cycle.

• Transportation firms and utilities are less dependent upon the

business cycle and hence should have low betas.
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Cyclicality of Revenues..contd..
• Note that cyclicality is not the same as
variability—stocks with high standard deviations
need not have high betas.
• Movie producing firms have revenues that are variable,
depending upon whether they produce “hits” or “flops”,
but their revenues are not especially dependent upon
the business cycle. Hence they tend to have high
variability (σ ) but not necessarily high beta.

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Operating Leverage
• The degree of operating leverage measures how
sensitive a firm’s (or project’s) EBIT is to its sales.
• Operating leverage increases as fixed costs rise and variable
costs fall. If most costs are fixed they do not decline when
demand and hence sales falls, then the firm will have high
DOL.
• Operating leverage magnifies the effect of cyclicality on beta.
• The degree of operating leverage is given by:

D EBIT Sales
DOL = ×
EBIT D Sales

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Operating Leverage..contd..

D EBIT
$ Total
costs

Fixed costs
D Volume

Fixed costs
Volume

Operating leverage increases as fixed costs rise and variable costs fall. The
Operating leverage of green firm is more than that of red firm. The profits
of the green firm are more responsive to changes in sales than the red
firm=> more business risk => higher unlevered beta.
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Impact of Financial Leverage ..levered

beta
• The presence of debt in a firm's capital structure results
in additional risk.
• The systematic risk inherent in the firm's basic business
operations is amplified by financial leverage.

• Why ?
• One source of additional risk is the increased risk of financial
distress (e.g., bankruptcy).

• A second source is the effect of financial leverage on the

volatility of shareholder's returns. The fixed obligations
associated with debt amplify the variations in a firm's
operating cash flows. The result is a more volatile stream of
shareholder returns

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Measuring Cost of equity ..levered beta

..contd..
• For investors to hold the shares of firms with debt
in their capital structures they must be
compensated for the additional risk generated by
financial leverage.

• The additional risk premium associated with the

presence of debt in a firm's capital structure is the
financial risk premium.

• RS = RF + BRP + FRP

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Measuring Cost of equity ..levered beta ..contd..

Expected
Return on
Financial risk
the Firm’s
premium
Stock

Business premium

Risk free rate

The Firm's Ratio of Debt to Equity ( D/E)

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Measuring Cost of equity ..levered

beta ..contd
• With financial leverage, the beta on a firm's stock reflects
both business and financial risk. This beta is called a levered
beta, βL and should capture the firm’s business risk and
financial risk.

• Employing a levered beta in the CAPM expression, the SML

measures both the business risk premium and the financial
risk premium.
• The cost of equity of such a firm is given by,
'
#& = # " + ! " %&%#$ ! ! # " !

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Relationship between levered and

unlevered beta
• Under the assumptions of CAPM there is a simple relationship
between levered and unlevered betas.

& "#
! E = ! D $& +%& ' #$ !
% !"

!)
• Alternatively, !* =
#
ED +&D ! $% !
"

• Therefore, a stock's beta (and its expected return) increases as its

debt equity ratio increases. The increase in beta reflects the
additional systematic risk generated by financial leverage. The
resulting increase in expected return reflects the increase in the
financial risk premium required by investors as compensation for
additional risk

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Un-levering and re-levering the observed

beta
• Suppose a firm has debt in its capital structure and is
having a certain D/E ratio. It is expecting to invest in a
new project for which it is going to raise additional
debt resulting in a new D/E ratio. How will the cost of
equity be impacted ?

• Can be estimated using a two step procedure .

• The first step involves un-levering the stock's beta.
Given its current debt ratio, D/E, its tax rate, t, and its
current observed beta, βL, its unlevered beta, βU can be
calculated from the equation presented before.

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Un-levering and re-levering the

observed beta ..contd..
• The second step consists of re-levering the stock's beta to
reflect a change in capital structure. Given βu ,the tax rate, t,
and the new, hypothetical debt ratio, D/E, the other equation
presented above Lcan be used to calculate the stock's new
leveraged beta, β .

• This ‘new’ levered beta is an estimate of the beta the stock

would have if it changed its debt ratio to that employed in the
second stage of the procedure.

• The resulting estimate of beta can then be plugged into the

familiar CAPM expression presented earlier, the Security
Market Line, to estimate the stock's expected return
associated with the proposed D/E ratio.

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Example

• Suppose Adani Power is thinking of investing in a new power

plant project. Its current observed( levered) beta is
• RM = 15% RF = 7% t = .50
"
• Adani Power’s current = = 0.33
! !
• Current ! "#A%& = 1.24
• Proposed "
!
for the new project is 1.0 . What is the
estimate of the current and new cost of equity ?
Suppose they are also planning to invest in another
small power plant which they intend to finance mostly
with equity and keep "! at a meagre 0.11. What would
then be the estimate of cost of equity ?

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Solution
• Current estimated cost of equity :
• Currently, D/E =0.33
• Currently Observed ( levered ) beta = 1.24
• Rs= rf + beta ( Rm-Rf)
• = 7% + 1.24*(15%-7%) = 16.92%

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Solution ..contd..
• Unlevering Adani’s Beta :
• ! = E
!)*)+, = (%*+ = 1.06
! "#"$% #
D ! + & ! ! $% ! )( + $%&'!$%##!"
"
"
• Re-levering Adani’s beta with the new proposed ! = 1.0
& "#
! D = ! & $! + % ! ' #$ ! = 1.06 [1+(.50)(1.0)]= 1.59
% !"

New estimated cost of equity, R’S = 7%+1.59*(15% - 7%) =

19.72%

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Solution .. Contd ..
SOME MORE SCENARIOS
Debt Ratio Adani’s Beta Adani’s estimated cost of
equity RS

Currently, D/E =.33 1.24 16.92%

unlevered, D/E =0 1.06 15.48%

proposed, D/E =.11 1.12 15.96%

proposed , D/E=1.00 1.59 19.72%

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The Decomposition of Expected Return into the

Risk Free Rate Business Risk Premium
and Financial Risk Premium
• Expected Return = risk free rate + business risk premium+
financial risk premium

• RS = RF + βU[RM - RF] + βU .(1 - t). (D/E) .[RM - RF]

• Alternatively,

• RS = RF + βU[RM - RF] + (βL - βU) [RM - RF]

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Decomposition of the expected return on

Adani's stock at different debt ratios
From previous example
Assumptions Debt Ratio Adani’s Beta( levered)

RM = 15% Currently, D/E =.33 1.24

RF = 7% unlevered, D/E =0 1.06
t = .50 proposed, D/E =.11 1.12
proposed , D/E=1.00 1.59

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Decomposition of the expected return on

Adani's stock at different debt ratios ..contd..
• Equation :
• Radani = RF + BRPadani + FRPadani

• Radani = RF + βU adani[RM - RF] + (βLadani - βUadani) [RM - RF]

• Example: Proposed, D/E =1.00

• Radani = 7% + 1.06[15% - 7%] +(1.59 – 1.06)[15% - 7%]

• i.e 19.72% = 7% + 8.48% + 4.24%

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Decomposition of the expected return on

Adani's stock at different debt ratios ..contd..

Summary results for other combinations

Debt Ratio RADANI = RF + BRPADANI + FRPADANI
Currently, D/E =.33 16.92% 7% 8.48% 1.44%
unlevered, D/E =0 15.48% 7% 8.48% 0%

proposed, D/E =.11 15.96% 7% 8.48% 0.48%

proposed , D/E=1.00 19.72% 7% 8.48% 4.24%

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Cost of equity.. Constant growth approach or

Gordon Growth model
• If dividends from the company are expected to grow at a
constant rate ‘g’,( typically mature companies with low to
moderate growth) then price of a stock is given by :
#&
$D =
"% ! !
• Where P0 is the current price of the stock, D1 is the dividend
expected at the end of one period from now and ‘rs’ is the
required rate of return from the stock by the market or
investors.
• Re arranging we can write , the required return on equity rs
as :
#
$D = & + !
"%
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Bond Yield + Risk Premium approach

• Some analysts use a subjective, ad hoc procedure to

estimate a firm’s cost of common equity by adding a
‘judgmental’ risk premium over the same firm’s yield on
issued bonds.
• Their logic is that the firms with risky, low rated and
consequently high interest rate debt will also have risky,
high cost equity.
• By this approach,
• rs = Bond Yield + Risk premium
• Empirically it has been seen that, risk premium over a firm’s
own bond yield has generally ranged from 3 to 5%. With
such a large range, this method gets a little subjective in
estimating cost of equity.
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Incorporation of Floatation costs

• Floatation costs are costs associated with issue of a
security. For example during issue of an IPO,
• the costs like underwriter fees,
• advertisement in print and electronic media etc. are
components of floatation cost.

• If debt is privately placed or if equity is raised

internally as retained earnings then there are
negligible or no floatation costs.

• However if the companies issue debt or new stock to

public then floatation costs can become important.

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Floatation costs .. Contd..

• There are two approaches typically used to incorporate floatation
costs:

• One approach is to adjust the original investment amount I by

the floatation cost percentage and hence modify the NPV or the
rate of return from the project.

• The adjustment is typically done as follows :

• If p% is the percentage of overall floatation cost for debt, equity and
preferred stock then I’*(100-p)% is the amount in hand after
floatation cost where

• I’ is the amount actually raised and this should be equal to I.

• i.e I’=I/(100-p)% which is the modified expense upfront.

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Practice Problem 19
• Your company is considering a project that will cost
$1 million. The project will generate after-tax cash
flows of $250,000 per year for 7 years. The WACC is
15% and the firm’s target D/E ratio is .6 The
flotation cost for equity is 5% and the flotation cost
for debt is 3%.
• What is the NPV of the project without considering
floatation cost?
• What is the NPV for the project after adjusting for
flotation costs?

• 40,000 , -4281
• module-2 -numericals.xlsx

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Adjusting for floatation costs ..

Contd..
• The second approach involves increasing the cost of
capital rather than increasing the projects investment
cost.
• The adjustment process is based on the following logic :
• If there are floatation costs the issuing firm receives only a
portion of the capital provided by investors with the
remaining going to the underwriter.
• To provide investors with their required rate of return on the
capital they contributed, each rupee the firm actually
receives must ‘work harder’ i.e each rupee must earn a
higher rate of return than the investors required rate of
return.

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Floatation costs .. Contd..

• For example in case of equity cost : the GGM approach can
be used to estimate the effects of floatation costs . The
equation used is as follows :
&!
D( = +!
%"$ ! ! "#

• Where F is the percentage floatation cost required to sell

the new stock, so P0(1-F) is the net price per share received
by the company.

• Similar adjustments for the price should also be made for

preferred stock or bond issues to find the appropriate cost
of preferred stock and debt.

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Practice Problem 20
• Javits and Sons’ common stock currently trades at
$30.00 a share. It is expected to pay an annual
dividend of $3.00 a share at the end of year (
D1=$3.00) and that is expected to grow at a constant
growth rate of 5% a year.
• a. What is the company’s cost of common equity if all
of its equity comes from retained earnings ?
• b. If the company issued new stock at the current
market price it would incur a 10% floatation cost.
What would be the cost of equity from new stock?
• 15%, 16.11%
• module-2 -numericals.xlsx

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problem 21
• A company has a debt equity ratio of 0.75. The
company is considering a new plant that will cost $125
million to build. When the company issues new
equity, it incurs a floatation cost of 8%.The floatation
cost on new debt is 3.5%.What will be the actual cost
of the plant if the company raises all equity
externally? What if it typically uses 60% retained
earnings? What if all equity investment is financed
through retained earnings?
• $133,079,848
• $129,303,975
• $126,903,553
• module-2 -numericals.xlsx

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Project cash Flows … a first look

• Now that we are convinced that wise investment decisions should be
based on the NPV rule, important question is ‘what to discount?’
while using the NPV rule.

• When you are faced with this problem , the following general rules
should be adhered to :

• Only cash flow is relevant, not profit

• Always estimate cash flows on an incremental basis
• Estimate cash flows on an after tax basis
• Consider incidental or side effects
• Consider working capital requirements
• Include opportunity costs
• Do not include sunk costs
• Do not include Financing costs in cash flows
• Adjust for inflation

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Only Cash Flow is relevant

• Sometimes cash flows are confused with accounting
profits, which should not be , because of the following
reasons :

• First :
• Accountants consider profit ‘as it is earned’ i.e a revenue is
considered as it accrues rather than when the company
actually receives the money from the customers.
• Similarly when an expense is incurred it is considered
immediately as an expense although actual cash outflow
towards that may happen later.

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Only Cash Flow is relevant ..contd..

• Second :
• they sort cash outflows into two categories : current
expenses and capital expenses.
• They deduct current expenses when calculating profits but
do not deduct capital expenses. Instead they depreciate
capital expenses over a number of years and deduct the
annual depreciation charge from profits.
• As a result the upfront expenditure is not included as an
expense at one go, while the later profits are reduced by the
depreciation charge which is not a cash outflow at all--- this
can have serious time value implications.

• Bottom line is cash flows are to be arrived at from

accounting statement of profits.

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Consider incremental or relevant

cash flows
• Cash Flows that need to be considered for taking a capital
budgeting decision must be ‘relevant’ and on an ‘incremental’
basis.

• Relevant Cash Flows :

• cash flows that occur because a project is undertaken. Cash
flows that will occur whether or not we accept a project are
not relevant cash flows.

• Defined in terms of the changes in or increments to the firm’s

existing cash flows.

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Consider after tax cash flows

• Cash flows to be considered on an after tax basis.

• Also make sure that

• taxes should be discounted from their actual payment
date, not from the time when the tax liability is recorded in
the firm’s books.( since cash flows should be recorded only
when they occur )

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Side effects: Cannibalization and Sales

creation

• With multi-line firms, projects often affect one

another or existing products – sometimes helping,
sometimes hurting. The point is, to be aware of such
effects in calculating incremental cash flows.
• Cannibalization – When a new product is introduced
it may take away the sales of existing products.
• Example : i) Suppose Kellogg’s brings out a new oat cereal, which will
probably reduce existing product sales.
• ii) Maruti brings out a new small car which will affect the sales of Alto
or other small cars.
• In this case the cash flows from the new product should be adjusted
downward to reflect lost profits on other lines.

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Side effects: Cannibalization and

Sales creation … contd…
• Sales Creation :
• This is opposite of cannibalization.
• The new project can also be complimentary to an
old one, in which case cash flows in the old
operation will be increased when the new one is
introduced.
• For example for some firms, when they set up
manufacturing facilities abroad their overall image may
go up and sales in the domestic market may increase.
In calculating the project‘s cash flows, the additional
sales and associated incremental cash flows should be
attributed to the project.

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Concept Check ..1

• Cool Comfort currently sells 300 Class A cars, 450
Class C cars, and 200 deluxe model cars each year. The
firm is considering adding a mid-class car and expects
that if it does it can sell 375 of them. However, if the
new car is added, Class A sales are expected to
decline to 225 units while the Class C sales are
expected to decline to 200. The sales of the deluxe
model will not be affected. Class A cars sell for an
average of $12,000 each. Class C cars are priced at
$6,000 and the deluxe model sells for $17,000 each.
The new mid-range car will sell for $8,000. What is
the value of the erosion?

• $2,400,000
• module-2 -numericals.xlsx
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Consider changes in Net working capital

• Most projects need investments in net working

capital in addition to long term assets.
• For example , a project will generally need some amount of cash in
hand to pay any expenses that arise. In addition the project will need
to invest in short term assets like accounts receivables, inventories ,
etc. This is partly financed by accounts payables but the balance needs
to be supplied which represents the investment in net working
capital.

• This has to be considered in the cash flow forecasts.

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Consider changes in Net working

capital…contd..`
• When the project comes to an end, this net working
capital gets recovered gradually.
• Inventories are sold, receivables are collected ,bills are paid
and cash balances can be drawn down. These activities free
up the net working capital originally invested.
• Thus the firm’s investment in net working capital is like a
loan that the firm gives initially to the project and then
recovers later as the project comes to an end.

• Changes in net working capital are to be adjusted from

revenues and profit figures to arrive at cash flow figures
for the project.
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Opportunity costs should be

considered
• Money that could be generated from an asset from
the next best alternative use that is given up by
taking up the project and using the asset in the
project.

• Example:
• An old warehouse is to be converted into a selling
outlet--- the next best alternative was to sell the
warehouse @$10,000. which is given up if the project is
taken. $10,000 is considered to be the opportunity cost.

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Concept Check ..2

• You own a house that you rent for $1,100 a month. The
maintenance expenses on the house average $200 a
month. The house cost $219,000 when you purchased it 4
years ago. A recent appraisal on the house valued it at
$239,000. If you sell the house you will incur $14,000 in
real estate fees. The annual property taxes are $4,000. You
are deciding whether to sell the house or convert it for
your own use as a professional office. What value should
you place on this house and what should be your relevant
cash flow against the house when analyzing the option of
using it as a professional office?

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Sunk Costs should not be considered

• Sunk cost – a cash flow already paid or accrued before the process of
making an investment decision begins.

• Like ‘spilled milk’. … already incurred and irreversible outflows. Because

sunk costs are bygones, they cannot affect the decision to accept or reject a
project and should not therefore be considered to be part of the project’s
relevant cash flows. ( relevant cash flows are cash flows that happen only if
the project is undertaken otherwise not) .

• For example, an initial viability study by a consultant requires the fees of

the consultant to be paid irrespective of whether the project is taken up or
not. So that should not be considered as a relevant cost flow for the
project.

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Financing Costs should not be considered

• In a typical capital Budgeting analysis , firms calculate the project’s cash flows
under the assumption that the project is financed only with equity. The
adjustments for debt financing are made in the discount rate rather than the
cash flows.
• This is done by discounting the project’s cash flows by a weighted average(WACC)
of the costs of debt, preferred stock and common equity adjusted for each
component’s risk. The WACC is the rate of return necessary to satisfy all of the
firm’s investors both stock holders and debt holders.

• Thus the cash flows in the numerator are the total cash flows available for all
the stakeholders in the project/company
• if we would have deducted interest expenses then the residual cash flows will be
the ones available only to equity holders) and
• the discount rate in the denominator is the effective rate that is required to
satisfy all the stakeholders in the company-the tax adjusted WACC.

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Financing Costs should not be

considered… contd…

• If you want to consider interest paid ( and other cash

flows to debt holders)as an outflow and deduct it from
cash flows, then you will need to change the discount
rate.

• In that case as you are effectively finding out the cash

flows to the equity holders of the project only. Hence
you will need to discount them by cost of equity rather
than WACC.
• In that case NPV can be calculated as PV of cash flow to equity
holders and deduct the contribution of the equity holders from
there.

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Cash Flow estimation

• Free Cash Flow Approach :
• We assume that the project ( firm) is an unlevered firm i.e no
interest payment is there in order to get the total cash flows
from the assets of the project/firm.
• a) Starting point :Finding out unlevered Operating cash
Flow
• is given by
• EBIT*(1-t)+ D
• =(Sales-COGS-D)*(1-t)+D
• =(Sales-VC-FC-D)*(1-t)+D
• = (Sales-VC-FC)*(1-t)+t*D
• t*D is also called the depreciation tax shield

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Adjusting For Working Capital

• b) Taking care of net working capital :
Working Capital Item Impact on Remarks
change Cash Flows
Receivables ↑ ↓ Lending /credit sales .. Cash gets
locked
Receivables decrease ↑ Payment recovered .. Cash ↑
Inventory ↑ ↓ More Investment in inventory .. Cash
↓

Inventory ↓ ↑ Some inventory converted into sales

and hence .. Cash ↑
Accounts payables ↓ ↓ Payment made … cash ↓

Accounts payables ↑ ↑ Payment to be made accumulated ..

Cash ↑

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Adjusting For Working Capital .. Contd..

• Instead of adjusting the individual items we can

simply adjust the change in net working capital
from profit, which is given by ∆CA - ∆CL= ∆NWC
• Increase in net working capital implies NCF should
be reduced , so that should be subtracted from
after tax profit, and decrease in net working
capital added to after tax profit
• Therefore eqn (2) above can be extended to
• NCF = EBIT(1-t)+ D- ∆NWC

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Adjusting for change in CAPEX

• C) Arriving at Free cash flow expression by taking care of

change in CAPEX:

• In addition to initial cash outlay(I), an investment project may

also require some reinvestment of cash flow( for example in
replacements of M/Cs etc) for maintaining the revenue
generating ability of the project during its life.

• As a consequence
• net cash flow will be reduced by the cash outflow for additional
capital expenditures(CAPEX).

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Finding ∆CAPEX
• IF Ending NFA = Beginning NFA - Depreciation
• THEN Net Capital Spending (∆CAPEX) = 0

• i.e ∆CAPEX = Ending NFA-Beginning NFA+Depreciation

Example :

Ending NFA 1,800

- Beginning NFA 1,600

+ Depreciation 65

= Net Capital Spending 265

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Free Cash Flow .. Final expression ..

• Therefore the free cash flow expression becomes finally :

• FCF = EBIT(1-t) +D - ∆NWC- ∆CAPEX

• This is also sometimes called the Free Cash Flow and it is the cash
flow that is available to service both bondholders and equity
holders ( and preferred equity holders , if any) who have supplied
respectively debt and equity ( and preferred equity).
• Hence the suitable discount rate to be used for discounting
this is WACC( post tax) .
• Method known as Free cash Flow approach or WACC approach.

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Cash Flow estimate for capital Budgeting.. Contd..

• d)Terminal cash Flows :

• Salvage value(SV) : market price that is available from an
investment at the end of its life when it is sold.
• The cash proceeds net of taxes will be a terminal cash flow in
the analysis.
• The tax treatment is as follows : Net proceeds = SV-T(SV-BV)
• a. If SV <BV ( book value) : loss , can claim a tax credit on loss,
• b. if SV>BV then profit , taxed at normal tax rate . Net proceeds = SV-
T(SV-BV)

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Practice Problem 23
• Phone Home Inc, is considering a new three year expansion
project that requires an initial fixed asset investment of $4.2
million. The fixed asset will be depreciated straight line to zero
over its three year tax life, after which time it will be worthless.
The project is estimated to generate $3,100,000 in annual sales ,
with costs of $990,000. If the tax rate is 35%, what is the OCF for
this project ?
• The required return on the project is 12%. What is the project’s
NPV?
• Suppose the project requires an initial investment in net
working capital of $300,000 ( to be recovered at the end) and
the fixed asset will have a market value of $210,000 at the end
of the project( book value is zero). What is the project’s year 0
net cash flow? Year 1? Year 2? Year 3? What is the new NPV?
• 1,861,500
• 271009
• 281700

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Example .. A capital budgeting problem

• Bharat Foods limited is a consumer goods manufacturing
company. It is considering a proposal of marketing a new
food product. The project will require an initial investment
of Rs. 1 million in plant and machinery. It is estimated that
the machinery can be sold for Rs 100,000 at the end of its
economic life of 6 years. Assume that the loss of profit on
the sale of the machine is subject to corporate tax rate.
The company can charge an annual written down
depreciation at 25% for the purpose of tax calculation.
• Assume that the company’s tax rate is 35% and the cost of
capital is 18%.
• Table1 provides the investment data and the summarized
profit and loss statement for the new product project.
Estimate the project's cash flows and determine its NPV
and IRR to conclude whether to go ahead or not.

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Table 1 : showing investment and profit and loss data

for the new product project

year 0 1 2 3 4 5 6
1 Initial investment 1000
2 Depreciation 250 188 141 105 79 59
Accumulated
3 Depreciation 250 438 578 684 763 822
4 Book value ( 1-4) 750 563 422 316 237 178
5 Net woking capital 20 30 50 70 70 30 0
6 Salvage Value 100
7 Revenues 550 890 1840 2020 1680 1300
8 Expenses 300 472 958 1075 890 680

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Table 2 : Cash Flow estimate and NPV and

IRR calculation
year 0 1 2 3 4 5 6
1 Initial investment -1000
2 Revenues 550 890 1840 2020 1680 1300
3 Expenses 300 472 958 1075 890 680
4 Depreciation 250 188 141 105 79 59
5 EBIT=2-3-4 0 231 741 840 711 561
6 EBIT*(1-t)=(5)*0.65 0 150 482 546 462 364
7 EBIT*(1-t)+Depcn=6+4 250 337 623 651 541 424
8 Change in Net WC 20 10 21 20 0 -40 -30
NCF ( ignoring change in
9 CAPEX)=7-8 -20 240 316 603 651 581 454
After tax salvage value
10 =[100-0.35(100-178) 127
11 Net cash flows=9+10 -20 240 316 603 651 581 581
Net cash flow considering
12 initial investment -1020 240 316 603 651 581 581

NPV 582
IRR 34.91%

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Other issues in Capital Budgeting

• Other Issues in capital Budgeting

• Analyzing Projects with Unequal lives
• Capital Budgeting Under Uncertainty and
project risk analysis
• Sensitivity analysis
• Scenario analysis

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Evaluating Projects with unequal

lives
• If a company is choosing between two projects and
those projects
• Have significantly different lives
• Are mutually exclusive and
• Can be repeated then
• The regular NPV method may not indicate the better
project.
• Then we apply either the Replacement chain
(common life) approach or Equivalent Annual
Annuity approach .

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Evaluating Projects with Unequal

Lives..contd..
§ Machines A and B are mutually exclusive, and will
be repurchased. If WACC = 10%, which is better?

Expected Net CFs

Year Machine A Machine B
0 ($50,000) ($50,000)
1 17,500 34,000
2 17,500 27,500
3 17,500 –
4 17,500 –
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Solving for NPV with No Repetition

• With no repetition considered
• NPVA = $5,472.65
• NPVB = $3,636.36
• Is Machine A better therefore?
• Need replacement chain and/or equivalent annual annuity
analysis.

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Replacement Chain
• Use the replacement chain to calculate an extended
NPVB to a common life.
• Since Machine B has a 2-year life and Machine A has
a 4-year life, the common life is 4 years.

0 1 2 3 4
10%

-50,000 34,000 27,500 34,000 27,500

-50,000
-22,500
NPVB = $6,641.62 (on extended basis)
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Equivalent Annual Annuity

• Using the previously solved project NPVs, the EAA is
the annual NPV that the project would provide if it
were an annuity.
• Machine A
• NPV= 5472.65= EAA*(PVIFA(10%,4)
• i.e EAAA = $1726.46
• Machine B
• NPV= 3636.36=EAA*PVIFA(10%,2)
• i.e EAAB= 2095.24
• Machine B is better!

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Risk analysis in capital Budgeting

• Project Risk :

• Computing an NPV is putting a market value on uncertain

future cash flows. Projecting the future involves the potential
for error and estimation of future cash flows is contingent on
many factors as follows :
• Forecasted cash flows will depend on expected revenue and costs . Expected
revenue will depend on sales volume and price . Sales volume will depend on
market share and size.
• Again costs include variable costs, which depend on sales volume
and unit variable costs and fixed costs.
• Since most of these are expected values , the actual values
may be different leading to riskiness of the project
•

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Risk analysis .. Contd..

• The techniques used to assess/address stand alone

risk are as follows :

• Sensitivity analysis
• Scenario analysis

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Sensitivity Analysis
• 1) Sensitivity Analysis :
• A way to analyse how much the project’s NPV or IRR
gets affected by a change in one of the input/affecting
variables ( on revenue side or cost side) other variables
being kept constant.

• The process is then repeated for all the variables one by

one and find out the most critical variable .

• The greater the volatility in NPV in relation to a specific

variable, the larger the forecasting risk associated with
that variable, the more attention we want to pay to its
estimation.

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Sensitivity Analysis …contd..

• The list of key input variables for a typical project
are:
• Equipment cost
• Required working capital
• Unit sales
• Sales Price
• Variable cost per unit
• Fixed operating costs
• Tax rate
• WACC

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Sensitivity Analysis …contd..

• Typically in a sensitivity analysis first of all a “base
case NPV” is found out
• Base case NPV is the NPV when the input variables are
set equal to their most likely ( or base case) values.
• Then during review the following kind of questions
may be asked :
• What if unit sales turns out to be 25% below the base
case level?
• What if market conditions force us to price the product
at 10% less than the base case level?
• What if variable costs are 20% higher than we
forecasted?

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Sensitivity Analysis …contd..

• Sensitivity analysis is designed to answer to such
questions.

• Each variable is increased or decreased from its

expected value, holding other variables constant at
their expected( base case) values.

• Then the new NPV is calculated using the changed

input. Finally the resulting set of NPVs is plotted to
show how sensitive NPV is to changes in each variable.

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Sensitivity Analysis ..Example

Suppose we have the following NPVs for various values of input variables changing
one at a time ,other variables remaining constant As we can see
the NPV is
NPV with variables at different deviations from base very sensitive
Deviation Equipment to changes in
from base Sales Price VC/Unit Units sold Fixed Costs cost WACC
25% $2,526.86 ($1,245.67) 1202.37 ($872.14) ($71.26) $33.62 Sales price,
0
-25%
78.82
(2369.22)
78.82
1403.31
78.82
(1044.73)
78.82
1029.78
78.82
228.9
78.82
127.62
fairly sensitive
Range $4,896.08 $2,648.98 $2,247.10 $1,901.92 $300.16 $94.00 to changes in
$3,000.00 variable costs,
a bit less
$2,526.86
sensitive to
$2,000.00
units sold and
1403.31 fixed costs ,
1202.37
1029.78 $1,000.00 sale s pri ce but not very
VC/unit sensitive to
228.9
127.62 $0.00 78.82 $33.62 unit sa les
changes in
($71.26)
-30% -20% -10% 0% 10% 20% 30% the
fixed costs
equipment
($1,000. 00) ($872.14)
-1044.73
($1,245.67)
equipment cost or WACC
costs
WACC
($2,000. 00)
-2369.22

($3,000. 00)
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Scenario Analysis
• Sensitivity Analysis assumes that the variables affecting the NPV are
independent of each other . So it analyses the effect one by one.
• However there can be inter relationship between variables. For example sales
volume and operating cost may both be related to price. A price cut may lead
to high sales and thus low operating costs.
• Scenario analysis examines what happens to the NPV under different cash
flow scenarios (caused by different combination of inputs)?
• At the very least look at:
• Best case – high revenues, low costs
• Worst case – low revenues, high costs
• Normal case – somewhere in between

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Scenario Analysis..example
Suppose we have the following NPV numbers after analysis for
the base case, best case and worst case scenarios
Figs in
,000 s Prob 0 1 2 3 4 WACC NPV

Best case 25% ($750) $2,685 $2,520 $2,390 $2,135 7.50% $7,450.38

Base case 50% ($1,000) $500 $400 $300 $100 10.00% $78.82

Worst Case 25% ($1,250) ($1,077) ($1,119) ($1,213) ($1,343) 12.50% ($4,782.40)
Expected NPV $706.40
SD $5,028.94

Coefficient of
Variation
=SD/Exp(NPV) $7.12

If the coefficient of variation for the firm’s average risk project is 2.0 , then a CV
of 7.12 would imply the project is considerably riskier than other projects of
the firm.
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• Capital structure

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Capital Structure and the Pie

• The value of a firm is defined to be the sum of the
value of the firm’s debt and the firm’s equity.
V=D+E
• If the goal of the firm’s
management is to make the E
S D
firm as valuable as possible,
then the firm should pick the
debt-equity ratio that makes
the pie as big as possible.
Value of the Firm
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Which capital structure( D/E) should the

firm choose ?
Financial Leverage, EPS, and ROE
Consider an all-equity firm ABC that is contemplating going into debt.
(Maybe some of the original shareholders want to cash out.) Ignore
taxes for the time being.

Current Proposed
Assets 20000 20000
Debt 0 8000
Equity 20000 12000
D/E 0.00 0.67
Interest Rate n/a 8%
Shares o/s 400 240
Share Price 50 50

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EPS and ROE Under Current Structure

Recession Expected Expansion
EBIT $1,000 $2,000 $3,000
Interest 0 0 0
Net income $1,000 $2,000 $3,000
EPS $2.50 $5.00 $7.50
ROA 5% 10% 15%
ROE 5% 10% 15%
Current Shares Outstanding = 400 shares

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EPS and ROE Under Proposed Structure

Recession Expected Expansion
EBIT $1,000 $2,000 $3,000
Interest 640 640 640
Net income $360 $1,360 $2,360
EPS $1.50 $5.67 $9.83
ROA 1.8% 6.8% 11.8%
ROE 3.0% 11.3% 19.7%
Proposed Shares Outstanding = 240 shares

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Financial Leverage and EPS

12.00

10.00 Debt

8.00 No Debt

6.00 Break-even Advantage

EPS

point to debt
4.00

2.00

0.00
1,000 2,000 3,000
(2.00) Disadvantage EBIT in dollars, no taxes
to debt
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Financial Leverage and earnings , ROE

• It may seem that leverage is beneficial, because EPS is

expected to be $ 5.67 with leverage and only $5.00
without leverage. ( same with ROE as well !)

• However, leverage also creates risk.

• Note that in a recession, EPS is higher ($2.50 versus $1.50) for
the unlevered firm.

• Thus, a risk-averse investor might prefer the all-equity

firm, while a risk-neutral (or less risk-averse) investor
might prefer leverage.
• Given this ambiguity, which capital structure is better?
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MM-Proposition I
• Modigliani and Miller (MM) have a convincing
argument that a firm cannot change the total value
of its outstanding securities by changing the
proportions of its capital structure.
• In other words,
• no capital structure is any better or worse than any
other capital structure for the firm’s stockholders.
• This statement is the famous MM Proposition I.

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Assumptions of the M&M Model

• Perfect Capital Markets:
• Perfect competition
• Firms and investors can borrow/lend at the same rate
• Equal access to all relevant information
• No transaction costs
• No taxes

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MM model : argument of homemade leverage

• Their argument compares a simple strategy, which

we call strategy A, with a two part strategy which
we call strategy B:
• Strategy A—Buy 40 shares of the levered
equity..@2000
• Strategy B:
• 1. Borrow $800 from either a bank or, more likely, a brokerage
house. (If the brokerage house is the lender, we say that this
is going on margin.)
• 2. Use the borrowed proceeds plus your own investment of
$12,00 to buy 40 shares of the unlevered firm.

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Homemade Leverage: An Example :

Strategy A : buying 40 shares of the levered firm( with D: E = 2: 3) @$50
per share using $2000 of own money

Recession Expected Expansion

EPS of Levered Firm $1.50 $5.67 $9.83
Earnings for 40 shares $60 $226.8 $393.2
Net earnings $60 $226.8 $393.2
ROE (earnings / $2,000) 3% 11.3% 19.7%

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Homemade Leverage: An Example

Strategy B : Let us now buy 40 shares of the unlevered firm @$50 per share
using $1200 of our own money and $800 borrowed money ( can be bought on
margin from a broker) ( Our own D : E ratio is 2: 3)
Recession Expected Expansion
EPS of Unlevered Firm $2.50 $5.00 $7.50
Earnings for 40 shares $100 $200 $300
Less interest on $800 (8%) $64 $64 $64
Net Profits $36 $136 $236
ROE (Net Profits / $1,200) 3.0% 11.3% 19.7%

We get the same ROE as if we bought into a levered firm.

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Homemade leverage example : implications

• This shows a very important result.

• Both the cost and the payoff from the two

strategies are the same.

• Thus, one must conclude that the firm is neither helping

nor hurting its stockholders by restructuring.

• In other words, an investor is not receiving anything

from corporate leverage that he or she could not
receive on their own.

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Homemade leverage example :

implications ..contd..
• Now suppose that, for whatever reason, the
value(price) of the levered firm’s stock were actually
greater than the value(price) of the unlevered firm.

• Here, Strategy A should cost more than Strategy B.

• In this case, an investor would prefer to borrow on his

own account and invest in the stock of the unlevered
firm. He would get the same net earnings each year as
if he had invested in the stock of the levered firm.
However, his cost would be less.
• The strategy would not be unique to our investor.

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Homemade leverage example :

implications ..contd..
• Given the higher value(price) of the levered firm, no rational
investor would invest in the stock of the levered firm.

• Anyone desiring shares in the levered firm would get the same
dollar return more cheaply by borrowing to finance a purchase
of the unlevered firm’s shares.

• The equilibrium result would be, of course, that the value of the
levered firm would fall, and the value of the unlevered firm
would rise until they became equal.

• At this point, individuals would be indifferent between Strategy

A and Strategy B.

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MM Proposition I (No Taxes)

• We can create a levered or unlevered position by
adjusting the trading in our own account.
• This homemade leverage suggests that capital
structure is irrelevant in determining the value of the
firm:
VL = VU
• A Key Assumption
• The MM result hinges on the assumption that
individuals can borrow as cheaply as corporations.
• If, alternatively, individuals can only borrow at a higher
rate, one can easily show that corporations can
increase firm value by borrowing.

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MM-Proposition II ( No taxes )
• From the example we have seen two important things :
• the expected return on unlevered equity is 10% while the
expected return on levered equity is 11.3%.

• So it may seem that : it does not matter whether the

corporation or the individual levers—as long as some
leverage takes place. Leverage benefits investors. After all, an
investor’s expected return rises with the amount of the
leverage present.
• Not necessarily.
• Though the expected return rises with leverage, the risk
rises as well.
• MM argue that the expected return on equity is positively
related to leverage, because the risk to equity holders
increases with leverage.

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MM Proposition II (No Taxes)..contd..

• Proposition II
• Leverage increases the risk and return to stockholders
Rs = R0 + (D / EL) (R0 - RD)

• implies that the required return on equity is a linear function of the firm’s debt-
to-equity ratio.

• Examining the relation we see that if R0 exceeds the debt rate, RD ,then the cost
of equity rises with increases in the debt-equity ratio, D/E.

• Normally, R0 should exceed RD. -- because even unlevered equity is risky, it should
have an expected return greater than that of riskless debt.
• Relation holds for our example firm ABC:
• 11.3% = 10% + (8000/12,000)*(10%-8%)

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MM-Proposition II ( No taxes ) ..contd..

• To derive this, we recall that the firm’s weighted average cost
of capital, rWACC,( no taxes) can be written as:

" "
C#A%% = ! C" + ! C!
"+! "+!
• where
• rD is the interest rate, also called the cost of debt
• rE is the expected return on equity or stock, also called the cost of equity
or the required return on equity
• rWACC is the firm’s weighted average cost of capital
• D is the value of the firm’s debt or bonds
• E is the value of the firm’s stock or equity

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MM-Proposition II ( No taxes ) ..contd..

• For our example :
% %
C!"## = ! C% + ! CA
%+A %+A
12F /0, 34+,-,F,. DEF*(
# &####
C!"## = ! '! + !"#! = "#!
# + &#### # + &####
12F /0, +,-,F,. DEF*(
'### "&###
C!"## = ! '! + !""%$! = "#!
'### + "&### '### + &####

• If we define, r0 as the cost of capital of an unlevered firm, in our

example r0 = Expected earnings to the unlevered firm/Unlevered
equity = 2000/20,000 = 10%
• rWACC is equal to r0 for ABC.
• In fact, rWACC must always equal r0 in a world without corporate
taxes.
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MM Proposition II (No Taxes)..contd..

Derivation :
" " &'#(%"#$%!"#AA = !!
C#A%% = ! C" + ! C!
"+! "+!
"+!
# " +,-)%.-"#!()*#$%&'$#!"##
! !# + ! !" = !! !
#+" #+"

#+" # #+" " #+"

! ! !# + ! ! !" = !!
" #+" " #+" "
# #+"
! !# + !" = !!
" "
# # !
! !# + !" = !! + !! #" = ## + " ## ! #! !
" " "

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MM Proposition II (No Taxes)..graphically

The cost of equity capital, rE is positively related to the firm’s debt equity ratio.
The firm’s weighted average cost of capital, rWACC, is invariant to the firm’s debt-
equity ratio. It is important to realize that r0, the cost of capital for an all-equity
firm, is represented by a single dot on the graph. By contrast, rWACC is an entire
line.)
!
#" = ## + " ## ! #! !
"

" "
C#A%% = ! C" + ! C!
R0 "+! "+!
Cost of capital: R (%)

RD RD

Debt-to-equity Ratio "

!

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SUMMARY OF MODIGLIANI-MILLERPROPOSITIONS
WITHOUT TAXES
• Assumptions:
• No taxes
• No transaction costs
• Individuals and corporations borrow at same rate
• Results:
• Proposition I: VL= VU (Value of levered firm equals value of
unlevered firm) !
• Proposition II: $# = $# + # " $# ! $! !
"
• Intuition:
• Proposition I: Through homemade leverage, individuals can
either duplicate or undo the effects of corporate leverage.
• Proposition II: The cost of equity rises with leverage, because
the risk to equity rises with leverage.

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 1/27/25

Practice Problem 25
• Rolston Corporation is comparing two different capital structures, an all-
equity plan (Plan I) and a levered plan (Plan II). Under Plan I, Rolston
would have 150,000 shares of stock outstanding. Under Plan II, there
would be 60,000 shares of stock outstanding and $1.5 million in debt
outstanding. The interest rate on the debt is 10 percent and there are no
taxes.
• a. If EBIT is $200,000, which plan will result in the higher EPS?
• b. If EBIT is $700,000, which plan will result in the higher EPS?
• c. What is the break-even EBIT?
• d. Use MM Proposition I to find the price per share of equity under each
of the two proposed plans. What is the value of the firm?
• A. EPS under Plan I : $1.33, under Plan II: $0.83
• B . EPS under Plan I : $ 4.67, under Plan II: $ 9.17
• C . Breakeven EBIT : $250,000
• D. $16.67 per share, Vu = $2500,000 and
• VL = $2,500,000, D=1500,000, E =1000,000

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Moving Closer to reality .. MM With taxes

• Though many have argued that individuals can only borrow

at rates above the corporate borrowing rate, that can be
contested .
• corporations frequently borrow using illiquid assets (e.g., plant and
equipment) as collateral. The costs to the lender of initial
negotiation and ongoing supervision, as well as of working out
arrangements in the event of financial distress, can be quite
substantial. Thus, it is difficult to argue that individuals must borrow
at higher rates than can corporations
• But when we look elsewhere for unrealistic assumptions in
the MM theory, we find two:
• 1. Taxes were ignored.
• 2. Bankruptcy costs and other agency costs were not considered.

• We turn to taxes next.

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MM Propositions I & II …(With Taxes)

In the presence of corporate taxes, the firm’s value is positively related to its
debt. The basic intuition can be seen from a pie chart, such as the one shown
• :
below
•The levered firm pays less in taxes than does the all-equity firm.
•Thus, the sum of the debt plus the equity of the levered firm is greater
than the equity of the unlevered firm.
•This is how cutting the pie differently can make the pie “larger.” -the
government takes a smaller slice of the pie!

All-equity firm Levered firm

E

E G G

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MM-I with taxes .. Example

• The XYZ Company has a corporate tax rate, TC of 35
percent and expected earnings before interest and
taxes (EBIT) of $1 million each year. Its entire earnings
after taxes are paid out as dividends. The firm is
considering two alternative capital structures. Under
plan I, XYZ would have no debt in its capital structure.
Under plan II, the company would have $4,000,000 of
debt. The cost of debt, rD is 10%.

• The chief financial officer for XYZ makes the following

calculations shown in the following table
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MM-I with taxes .. Example ..contd..

Plan I Plan II
Earnings before interest and corporate taxes (EBIT) $1,000,000 $1,000,000

Interest (rDD) 0 (400,000)

Earnings before taxes (EBT) = (EBIT - rDD) 1,000,000 600,000
Taxes (TC =0.35) (350,000) (210,000)
Earnings after corporate taxes 650,000 390,000
(EAT) = [(EBIT - rDD) (1 - TC)]
Total cash flow to both stockholders and $ 650,000 790,000
bondholders( add interest)
[EBIT*(1 - TC) + TCrDD]
Tc*rd*D=35%*
10%*4000,000
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MM-I with taxes .. Example

..contd..
• The most relevant numbers for our purposes are the two on the
bottom line.

• Dividends, which are equal to earnings after taxes in this example,

are the cash flow to stockholders, and interest is the cash flow to
bondholders.

• Here, we see that more cash flow reaches the owners of the firm
(both stockholders and bondholders) under plan II. The difference
is $140,000 =$790,000 -$650,000.

• The source of this difference can be easily traced. The govt.

receives less taxes under plan II ($210,000) than it does under plan I
($350,000). The difference here is $140,000 = $350,000 - $210,000.

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 1/27/25

MM-I with taxes : Present Value of the tax shield

• This interest is $400,000 (10% x $4,000,000) for XYZ. All this interest
is tax deductible. That is, whatever be the taxable income of XYZ
would have been without debt, the taxable income is now $400,000
less with the debt.

-*+B#B.+ = #/ ! /
!
! D(")*+ !"##"AB&
-*+B#B.+ #I+B

-$./0#I1" I" #(* = ! + ! %D ! D

! $#"
)(* %(#$ !"#$%$C#

• For XYZ, the reduction in corporate taxes is $140,000 (= 0.35x 10%x

4,000,000).
• Expression above is often called the tax shield from debt.
• Typically it is an annual amount.

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MM-I with taxes : Present Value of the tax

shield …contd…

• As long as the firm expects to be in a positive tax bracket,

we can assume that the tax shield has the same risk as the
interest on the debt. Thus, its value can be determined by
discounting at the interest rate, rD.

• Assuming that the cash flows are perpetual, the present

value of the tax shield is
! % "! !
#$,-. &D()*+ = =!% ! !
"!

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MM-I with taxes : Value of the Levered Firm

• We have just calculated the present value of the tax shield from debt. Our next
step is to calculate the value of the levered firm. The annual after-tax cash flow
of an unlevered firm is
• EBIT X (1 - TC)
• where EBIT is earnings before interest and taxes.
• The value of an unlevered firm (that is, a firm with no debt) is the present
value of EBIT X (1 - TC)

*+IC$!$E)'$C" B$$
"! =
#!
• where
• VU = Present value of an unlevered firm
• EBIT x (1- TC) = Firm cash flows(unlevered) after corporate taxes
• TC = Corporate tax rate
• r0 =The cost of capital to an all-equity firm. As can be seen from the
formula, r0 now discounts after-tax cash flows.

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MM-I with taxes : Value of the Levered

Firm..contd….
• As shown previously, leverage increases the value of the firm
by the tax shield, which is TCD for perpetual debt. Thus, we
merely add this tax shield to the value of the unlevered firm
to get the value of the levered firm.

*+I"#!#E) D#"- C## "- #! !

$" = +
B/ #!
=#$. +##"- !

• This is MM-Proposition I with taxes

• The first term in equation is the value of the cash flows of the
firm with no debt tax shield. In other words, this term is equal
to VU, the value of the all-equity firm.
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MM-I with taxes : Value of the

Levered
Firm..contd….
• The value of the levered firm is the value of an all-equity
firm plus TCD, the tax rate times the value of the debt.
• TCD is the present value of the tax shield in the case of perpetual
cash flows.

• Because the tax shield increases with the amount of debt,

the firm can raise its total cash flow and its value by
substituting debt for equity.

• This relationship holds when the debt level is assumed to

be constant through time and cash flow to debt holders is
perpetual in nature .
• A different formula would apply if the debt level is non-constant
over time and or have a finite life.

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MM Proposition I (With Taxes).. Algebraic derivation

3,+&(-().&2)%,&0.-1&(-&)..&%()*+,-./+'%&$%
# $BC# ! "! !! " #" ! #D ! + "! !

The present value of this stream of cash flows is VL

$%C'(%)*# $BC# ! "! !! " #" ! #D ! + "! ! =
= $BC# " #" ! #D ! ! "! ! " #" ! #D ! + "! !
= $BC# " #" ! #D ! ! "! ! + "! !#D + "! !
The present value of the first term is VU
The present value of the second term is TCD

!!#C = #% + "$ !

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Tax Shield with finite debt

• The following example calculates the present value if we assume the debt
has a finite life.
• Suppose the ABC company has $1 million in debt with an 8-percent
coupon rate. If the debt matures in two years and the cost of debt capital,
rD, is 10 percent, what is the present value of the tax shields if the
corporate tax rate is 35 percent? The debt is amortized in equal
installments over two years.

Year Loan Balance Interest Tax Shield Present Value of

Tax Shield
0 $1,000,000
1 500,000 $80,000 0.35 X $80,000 $25,454.54
2 0 40,000 0.35 $40,000 11,570.25
$37,024.79

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Tax Shield with finite debt …contd..

• The present value of the tax savings is

$#(+ ! ,$'$$$ $#(+ ! &$'$$$

!" = + = )(!'$%&#!"
*#*$ *#*$ %

• The ABC Company’s value is higher than that of a

comparable unlevered firm by $37,024.79.

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The Effect of Financial Leverage (with taxes ) on required

rates of return
Cost of capital: R !
(%) $# = $# + " " $# ! $! !
#"

D
B$ = B$ + " "# ! C" ! " " B$ ! B! !
$#

R0

A !"
D%C## = ! DA ! #" " E# ! + ! D!
A+!" A + !"
RD

Debt-to-equity
ratio (D/E)

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MM Proposition II (No Taxes)..graphically

The cost of equity capital, rE is positively related to the firm’s debt equity ratio.
The firm’s weighted average cost of capital, rWACC, is invariant to the firm’s debt-
equity ratio. It is important to realize that r0, the cost of capital for an all-equity
firm, is represented by a single dot on the graph. By contrast, rWACC is an entire
line.)
!
#" = ## + " ## ! #! !
"

" "
C#A%% = ! C" + ! C!
R0 "+! "+!
Cost of capital: R (%)

RD RD

Debt-to-equity Ratio "

!

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SUMMARY OF MODIGLIANI-MILLERPROPOSITIONS
WITH CORPORATE TAXES
• Assumptions:
• Corporations are taxed at the rate TC, on earnings after interest.
• No transaction costs.
• Individuals and corporations borrow at same rate.
• Results :
• M&M Proposition I: VL = VU + TC D
!
• M&M Proposition II : %$ = %$ + $ " "# ! C" ! " " %$ ! %! !
#

• Intuition:
• Proposition I: Since corporations can deduct interest payments but
not dividend payments, corporate leverage lowers tax payments.
• Proposition II: The cost of equity rises with leverage, because the
risk to equity rises with leverage.

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