Lecture 13

Valuation with
Leverage

Class 12: Summary

The required return on debt is lower than the required
return on equity:

Debt is senior

Modigliani-Miller (M&M) irrelevance results. Under perfect

capital markets:
1.

Leverage by itself does not increase firm value

1.
2.

2.

Leverage (debt financing) increases the risk of equity

The benefit of debts lower cost is exactly offset by the higher equity cost
of capital (higher equity risk)

The WACC is unaffected by financing

M&M: the capital structure benchmark

M&M: focus on the key source of value
Cash flows, cash flows, cash flows!
2

Beyond M&M
Capital structure decisions seem to matter. Evidence:
Stock prices react to financing decisions
Increase if firms: increase leverage
Decrease if firms: decrease leverage

Corporations spend resources on capital structure design

Ex. Investment banking fees

Managers are reluctant to change them:

Tell a CFO that debt policy does not matter

M&M does not predict any patterns for capital structure

But, capital structure shows lots of patterns
Across time for a given firm: life cycle
Across industries: different asset or cash-flow characteristics
Across countries: different institutional factors
3

Leverage and Taxes

MM relied on perfect or frictionless capital markets
MM: any capital structure is as good as any other!

Thus, capital structure must matter due to some market

imperfection that affects cash-flows/value

Corporate income taxes

Bankruptcy costs
Agency costs (incentives)
Differences in information
Security mispricing

Corporate income taxes:

Can leverage be used to reduce the corporate income taxes that
the firm must pay, and thereby increase its value for investors?
4

The Corporate Income Tax

Income Statement
2010

2011

2012

2013

2014

Sales Revenues

4,405

4,669

4,985

5,347

5,747

Cost of Goods Sold

-2,908

-3,059

-3,240

-3,448

-3,679

SG&A Expenses

-705

-747

-797

-856

-920

Depreciation

-132

-140

-149

-160

-172

Operating Income

660

724

799

883

976

Interest expenses
deducted before
tax
No corresponding
deduction for
dividends or share
repurchases

Other Income

13

10

15

20

24

EBIT

673

734

814

903

1,000

Interest Expense

-65

-65

-80

-100

-100

Income Before Tax

608

669

734

803

900

Taxes (35%)

-213

-234

-257

-281

-315

Net Income

395

435

477

522

585

Gain from Leverage

With vs. Without Leverage (2014)
All Equity Firm
EBIT

Levered Firm

$1000

$1000

$0

$100

$1000

$900

Tax at 35%

$350

$315

Net Income to Equity

$650

$585

Interest Paid to Debt Holders

Pre-Tax Income

What is the benefit?

Total income to all investors:
All equity firm = $650
Levered firm = 100 + 585 = $685
Gain from leverage = 685 650 = $35

All Equity Firm

$650

Levered Firm
$585 (equity)
$100 (debt)
$685

Tax savings = 350 315 = $35

6

The Interest Tax Shield

Debt gives the firm an interest tax shield which reduces taxes
each year:
Tax reduction = Corporate Tax Rate Interest Payments

This tax shield:

Reduces the taxes paid by the firm
Increases the net-of tax cash-flows available to both debt and equity
Increases the value of the firm:
PV(future interest tax shields) = Tc PV(future interest payments)
Tc : corporate tax rate

Value of the Interest Tax Shield

Special and simplest case:
Firm increases debt by D permanently: perpetually rolled over
Each period, the tax shield is = Tc D rD. Given that D is permanent, the
present value of tax shields is:
PV ( ITS )

Tc D rD
Tc D
rD

Gain from leverage:

V(Levered Firm) = V(Unlevered) + Tc D

Change in value:

V(Levered Firm) = 1 + Tc D
V(Unlevered)
V(Unlev)

Are these effects meaningful?

If Tc= 35%:
for D / V(Unlev)= 20%, firm value increases by about 7%
for D / V(Unlev)= 50%, firm value increases by about 17.5%
Bottom line: debt tax shields matter!

What happens if a competent CEO does not want to lever up?

Call Offer !!!! Do it! or someone will do it for you!

Weighted Average Cost of Capital

The After-Tax Cost of Debt
Each $1 of interest paid gives the firm a $0.35 tax benefit
Net after-tax cost of paying $1 in interest is only $0.65!
Effective after-tax interest rate on debt = rD (1 Tc)
Unchanged by
leverage ratio

Pretax WACC:
rWACC

E
D
rE
rD
DE
DE

ru
Decreasing
with leverage

WACC with Taxes:

rWACC

E
D
rE
rD (1 TC )
DE
DE

ru

D
TC rD
DE

u-unlevered
9

Weighted Average Cost of Capital

40%
35%
30%
25%
20%

Equity Cost of Capital r E

pretax WACC

15%
WACC with taxes

10%
Debt Cost of Capital r

5%

After-Tax Debt Cost of Capital r (1 )

D
c

0%
0%

20%

40%

60%

80%

100%

% Debt-to-Value Ratio D/(E+D)

10

2/5/2015
For years, RadioShack the retailer that helped bring personal
computers to the masses outlasted untold predictions that it
would buckle in the face of bigger rivals and online competitors.
But its clock has finally run out.
RadioShack which listed $1.2 billion in assets and nearly $1.4
billion in total debt could still survive in a much smaller form.

11

Mexico

12

Optimal Leverage
Fact: firms dont fully exploit the interest tax shield
What is the tradeoff?
60
50
Interest/EBIT

40
30
20
10
0
1975

1980

1985

1990

1995

2000

2005

2010

13

Direct and indirect costs of financial distress

If debt tax savings are so large what limits debt use?
Direct bankruptcy costs:

Cost of the legal proceedings around reorganization or liquidation

Any costs directly related to the event of bankruptcy:

Legal fees
Accounting fees
Advisory fees

Indirect costs of financial distress:

Loss of (or damage to) intangibles, such as brands

Difficulty retaining valuable employees
Difficulty of maintaining relationships with customers and suppliers
Distortions to investment behavior when firm is close to default
Distortions to managers incentives when firm is close to default

14

Example cost of financial distress: GM

This idea that you just go into Chapter 11 and hang
around for three months and agree to reduce your debt
obligations and don't pay your retirees, this is a fantasy.
Most people will stop buying the cars of a bankrupt
company.
Rick Wagoner (Source: Reuters, Nov 16, 2008)

15

Trade-Off theory of capital structure

Firms trade off tax benefits of debt against bankruptcy
and financial distress costs
Optimal leverage ratio is determined by:
a. The value and probability of using tax shields, and
b. The costs and probability of financial distress
Characteristic
Profitability
Nondebttaxshields(eg.Depreciation)
Tangibilityofassets
Volatilityofcashflows
Size
Indirectcostsoffinancialdistress*

EffectonOptimalLeverage
Positive
Negative
Positive
Negative
Positive
Negative

*Customerconfidence,laborforcemightleave,supplierswon'tship,etc)

16

Tradeoff Theory
Optimal leverage balances tax advantages and direct
and indirect bankruptcy costs

17

Valuation with Leverage

Main methods for valuing a firm or project with leverage
WACC: Weighted Average Cost of Capital Method: this class
Cash Flows:
Discount Rate:
Determines:

Unlevered Free Cash Flow

WACC (after tax) using constant leverage ratio
Enterprise Value

APV: Adjusted Present Value Method (Corporate finance class, etc.)

Cash Flows:
Discount Rates:
Determines:

Unlevered Free Cash Flow

Interest Tax Shield
Unlevered (Asset) Cost of Capital
Tax Shield Cost of Capital
Enterprise Value

18

Example: Diptron Incs expansion

A manufacturer of electronic switches is evaluating an expansion:

1.
2.
3.

$60 million expansion

Expected to increase its FCF by $7.5 m the first year, with 4% growth thereafter
Diptrons tax rate is 40%
The debt-equity ratio is 1/3 or D/(D+E)=25%
The equity cost of capital is 14.33%, and its cost of debt is 5% (pre-tax)

Questions:
What is the WACC?
What is the NPV of this project?
How large are the expected tax savings from using debt financing?

19

Solution
Unlevered Cost of Capital: Diptrons pre-tax WACC:

NPV without leverage

Tax savings:

20

10

WACC Method: Assumptions

Assumptions:
Risk:
Expansion has similar risk to the rest of the firm
Leverage: Diptron D/E = D/E project today and in the future

How much debt will Diptron use to fund the expansion?

Capital structure = 75% equity + 25% debt (market value)
25% $60 million investment

= $15 million

25% $40 million inc. in mkt value = $10 million

Total new debt

= $25 million

21

Adjusted Present Value (APV) Method

Unlevered Cost of Capital: Diptrons pre-tax WACC:
rUnlevered

= (E/V) rE + (D/V) rD = 75% 14.3333% + 25% 5.0%

= 12%

NPV without leverage

NPVU = -60 + 7.5/(12% - 4%) = -60 + 93.75 = $33.75 million

Interest Tax Shield

First Year: $25 million 5% 40% = $0.5 million
PV(Int Tax Shield) = 0.5/(12% - 4%) = $6.25 million

Adjusted Present Value

Increases
by 4%/yr
Same risk
as project

APV = NPVU + PV(Int Tax Shield) = 33.75 + 6.25 = $40 million

U-unlevered

22

11

Alternative Leverage Policies

Suppose Diptron will not maintain a fixed D/E ratio
Instead Diptron plans to:
Borrow $60 million initially
Repay $60 million after 2 years

NPV without leverage

NPVU = -60 + 7.5/(12% - 4%) = -60 + 93.75 = $33.75 million

Interest Tax Shield

Interest
Interesttaxshield
PresentvalueITS(at12%)
PresentvalueITS(at5%)

Sum

Year1

Year2

2,028
2,231

3,000
1,200
1,071
1,143

3,000
1,200
957
1,088

APV (at 5%) = 33.75 + 2.23 = $35.98 million

23

Valuation Methods in Practice

WACC is the most common method
Easiest to apply when the project has a constant target D/E ratio
Implicitly assumes that the debt tax savings are as risky as the
projects cash flows
Important note:
Many firms calculate a single firm-wide WACC and apply it to all
new projects: that is typically wrong!
Only valid if all projects have:
(a) same target D/E as the firm and
(b) similar business risk

APV is useful if the leverage ratio (D/E) is not constant

Easiest to apply when future debt levels are known
Easy to use a different (lower) discount rate for the debt tax
savings
Easy to adjust for other costs or benefits of debt
24

12

Big picture

25

26

13

Belgium: Notional Interest Deduction

Since 2006, firms receive a tax deduction based on the
book value of equity (deduction=Equity*rD)
Level the financing playing field
Percentages

44%

42%

PreReform

PostReform

40%

38%

36%

34%

32%

30%
2002

2003

2004

2005

2006

2007

2008

2009

Equitytoassetsratio

Source: Panier, Perez-Gonzalez and Villanueva (2014)

27

Summary
M&M: capital structure affects value if D,E affect cash flows
Corporate income taxes: Interest payments are tax-deductible.
Debt financing can increase the net-of-tax cash flows and hence value
M&M intuition holds

Trade-off theory of capital structure. Firms choose an optimal level of

debt financing that balances:
1. The tax benefit of using debt financing (tax-shield) against
2. The costs of financial distress (ex. bankruptcy costs)

Valuation methods to capture the effect of debt tax shields on firm value:
WACC: discount FCFs using the weighted average of after-tax debt costs and
equity costs
Adjusted Present Value (APV). Two steps:
1. Value projects as if 100% equity financed: FCFs & all-equity cost of capital
2. Add the present value of the tax shield of debt: using the expected interest
tax shield and the tax shield cost of capital
28

14