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Financial Management ­ MGT201
VU
Lesson 35
NET INCOME AND TAX SHIELD APPROACHES TO WACC.
Learning Objectives:
After going through this lecture, you would be able to have an understanding of the following topic:
·  Net Income & Tax Shield Approaches to WACC
In the last lecture we discussed the impact of debt on firm value under Miller Modigliani approach
in detail with numerical examples. We also discussed the formulae to see the impact of debt on firm
value under traditionalist real market concepts. Now we continue the same discussion with the help of
an example under traditionalist real market views:
Traditionalists -Real Markets Example:
The following example will help to understand how we can calculate WACC for a firm in the
real world:
A 100% Equity Firm (or Un-levered) has Total Assets of Rs.1000. It has a WACCU of 21% and
rD,U of 10%. It then adds Rs.400 of Debt. Financial Risk increases rD,L of Levered Firm to 13%. What is
the Levered Firm's rE,L and WACCL ? Tax rate is 30%.
Debt
rD(Interest) rE
EBIT
NI
Equity
Market Value WACC
(Given D)
(Given)
(Given)
(Rs.)
(Rs.) (E=NI/ rE)
(=D+E)
(%)
Rs.0 (=V)
0
21%
300
210
Rs.1000
Rs.1000
21%
Rs.200
10% (rRF)
22%
300
189
Rs.859
Rs.1059
17.9%
Rs.300
11%
23%
300
187
Rs.813
Rs.1113
16.8%
Rs.400
13%
28%
300
183
Rs.653
Rs.1053
17.4%
Rs.500
14%
33%
300
179
Rs.541
Rs.1041
17.2%
·
Un levered Case: D=0 , rE = 21% = WACC,
Market value of Equity = E = V = Market value of Firm (due to no debt) = Rs1000
·
Leverage: Debt (and Leverage) is gradually increasing from Rs.200 to Rs.500. Change in
Leverage Changes the Firm's Value. When Debt = Rs.400 value of firm has Increased to
Rs.1053 under traditionalist view whereas we assumed firm value fixed at Rs.1000 in Pure MM
Ideal Market Example. Rise in value of firm is due to interest savings.
·
Optimal Capital Structure occurs at Debt of Rs.300
(i.e. xD = D / V = Rs.300 / Rs.1113 = 0.2695). So a Financial Leverage of 26.95% is the Best
Capital Structure for this Firm. Here, WACC = 16.8% and value of the firm at its highest =
Rs.1113.
·
After this point value of firm starts falling and WACC rising.
Traditionalist View - Real Markets
Bankruptcy Risk &WACC Graph
Cost of
Costs. Higher
Required Return on
Capital
rE,L = Cost of Equity =
Equity. Steeper Rise.
(%)
WACCU + xD(WACCU -rD) (1-TC)
WACCL = rD(1-Tc)xD + rExE
rE
rD = Cost of Debt
rD
Interest Tax Shield
Advantage
Debt / Equity =
100%
Optimal Capital
Measure of Leverage
Equity
Structure
Firm
D/E = xD / ( 1- xD )
Minimum WACC &
Note: xD = D / (D+E)
Maximum Market Value
151
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Financial Management ­ MGT201
VU
Here cost of equity for a levered firm rises very fast. Also cost of debt rises. Recall we have studied this
graph earlier in previous lectures. Here point to note is that WACC line has become curve with a
minimum point at its lowest. Initially it comes down as it moves away from Y-axis and then after
reaching its minimum it starts going up. The minimum point at WACC is the best optimal point for firm
to operate for it capital structure.
Traditionalists - Real Markets Effect of Leverage on WACC:
·  Interest Tax Savings Increase, Cost of Interest or Mark-up Increases, and Cost of Equity
Increase. Depending on the Rate of Increase, they can affect computation of Firm's Market
Value (V) and WACC in different ways - either making them Increase or Decrease.
·  Effect of Increasing Leverage (as measured by Debt/Equity or xD = Debt/Value) on MARKET
VALUE of Firm (V) is Uncertain. Based on Combination of EBIT, Tax Rate, Leverage, and
Relative Costs of Debt & Equity.
·  Practically speaking, Initially Leverage adds Interest Tax Savings Benefit so Value (V) rises but
after some point the Cost associated with Financial Distress and Bankruptcy Risk makes the
Value Fall. MARKET VALUE of Firm (V) typically reaches a MAXIMUM VALUE where
WACC is MINIMUM. This is the Optimal Capital Structure.
NI Approach for Calculating Numerical value of WACC of Levered Firm ­ Example:
·  Starting Point for Calculating Numerical Value of WACC suing NI Approach is EBIT of Firm
= Rs.100 and Corporate Tax Rate, Tc = 30%
­  If the Firm is 100% Equity (or Un-Levered) and rE = 20% then what is the WACCU of
Un-levered Firm?
·
Net Income = EBIT - Interest - Tax
= 100 - 0 - 0.3(100)
= Rs.70
·
Market Value of Un-levered Equity = Eu
= NI / rE
= 70 / 0.2
= Rs.350
·
Market Value of Un-levered Firm = Vu
= Equity + Debt
= 350 + 0
= Rs.350
·
WACC u = rE,U
= 20%
­
If the Firm takes Rs.100 Debt at 10% Interest or Mark-up then what is the WACCL of
Levered Firm?
·  Net Income (NI)
= 100 - 10 %( 100) - Tax
= 100 - 10 - 0.3(90)
= Rs.63
·  Equity
= NI / rE
= 63 / 0.2
= Rs.315 (Major Assumption: No change in rE)
·  VL = Equity + Debt
= 315 + 100
= Rs.415. (Increasing Debt ADDS Value!)
·  WACCL
= rD,L (1-Tc) xD + rE,LxE
= 0.1(1-0.3) (100/415) + 0.2(315/415)
= 16.9%
Point to note is that WACCL is lower than WACCU.
152
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Financial Management ­ MGT201
VU
·  Sequence of Steps:
(1) Calculate NI = EBIT - Interest - Tax
(2) Calculate E = NI / rE
(3) Calculate VL = Equity + Debt
(4) Calculate WACCL
Tax Shield Approach (or NOI Approach) to Calculating WACC of Levered Firm:
Tax Shield = corporate tax rate * value of debt = Tc * D
·
Relationships between Un-Levered Costs and Levered Costs of Capital
·
Sequence of Steps for NOI Approach for Calculating Numerical Value of WACC for Levered
Firm:
­  Step 1: Starting Point is Market Value of Levered Firm
= VL = Vu + Tc D.
Unrealistic because VL should NOT keep increasing with Debt
­  Step 2: Tc x D = Tax Shield Advantage from Debt.
­  Step 3: Market Value of Equity = E = VL - D.
­  Step 4: Calculate rE,L = NI / E.
­  Step 5: Calculate WACCL = rD,L(1-Tc) xD + rE,LxE
­  Note: WACCL =WACCU (1-Tc) xD
·
Use Either NI Approach or Tax Shield Approach depending on what Data has been given to you.
Other Short-cut Formulas & Link between Capital Structure & Betas
·  Cost of Equity (After Tax) Estimates and STOCK BETAS
­  rE,L = WACCU + xD (WACCU -rD) (1-Tc)
­  rE,L = rE,U + Debt/Equity (rE,U -rD) (1-Tc)
­  rE,U = rRF + BETAE ( rM - rRF )
Recall from CAPM Theory
·  WACC (After Tax) Estimates AND FIRM BETA
­  WACCL = rD,L(1-Tc)xD + rE,LxE
­  WACCL = rRF + BETAWACC,L ( rM - rRF )
­
Note: Overall Beta for the Firm
= BETAWACC,L = BetaD xD + BetaE xE
153
Table of Contents:
  1. INTRODUCTION TO FINANCIAL MANAGEMENT:Corporate Financing & Capital Structure,
  2. OBJECTIVES OF FINANCIAL MANAGEMENT, FINANCIAL ASSETS AND FINANCIAL MARKETS:Real Assets, Bond
  3. ANALYSIS OF FINANCIAL STATEMENTS:Basic Financial Statements, Profit & Loss account or Income Statement
  4. TIME VALUE OF MONEY:Discounting & Net Present Value (NPV), Interest Theory
  5. FINANCIAL FORECASTING AND FINANCIAL PLANNING:Planning Documents, Drawback of Percent of Sales Method
  6. PRESENT VALUE AND DISCOUNTING:Interest Rates for Discounting Calculations
  7. DISCOUNTING CASH FLOW ANALYSIS, ANNUITIES AND PERPETUITIES:Multiple Compounding
  8. CAPITAL BUDGETING AND CAPITAL BUDGETING TECHNIQUES:Techniques of capital budgeting, Pay back period
  9. NET PRESENT VALUE (NPV) AND INTERNAL RATE OF RETURN (IRR):RANKING TWO DIFFERENT INVESTMENTS
  10. PROJECT CASH FLOWS, PROJECT TIMING, COMPARING PROJECTS, AND MODIFIED INTERNAL RATE OF RETURN (MIRR)
  11. SOME SPECIAL AREAS OF CAPITAL BUDGETING:SOME SPECIAL AREAS OF CAPITAL BUDGETING, SOME SPECIAL AREAS OF CAPITAL BUDGETING
  12. CAPITAL RATIONING AND INTERPRETATION OF IRR AND NPV WITH LIMITED CAPITAL.:Types of Problems in Capital Rationing
  13. BONDS AND CLASSIFICATION OF BONDS:Textile Weaving Factory Case Study, Characteristics of bonds, Convertible Bonds
  14. BONDS’ VALUATION:Long Bond - Risk Theory, Bond Portfolio Theory, Interest Rate Tradeoff
  15. BONDS VALUATION AND YIELD ON BONDS:Present Value formula for the bond
  16. INTRODUCTION TO STOCKS AND STOCK VALUATION:Share Concept, Finite Investment
  17. COMMON STOCK PRICING AND DIVIDEND GROWTH MODELS:Preferred Stock, Perpetual Investment
  18. COMMON STOCKS – RATE OF RETURN AND EPS PRICING MODEL:Earnings per Share (EPS) Pricing Model
  19. INTRODUCTION TO RISK, RISK AND RETURN FOR A SINGLE STOCK INVESTMENT:Diversifiable Risk, Diversification
  20. RISK FOR A SINGLE STOCK INVESTMENT, PROBABILITY GRAPHS AND COEFFICIENT OF VARIATION
  21. 2- STOCK PORTFOLIO THEORY, RISK AND EXPECTED RETURN:Diversification, Definition of Terms
  22. PORTFOLIO RISK ANALYSIS AND EFFICIENT PORTFOLIO MAPS
  23. EFFICIENT PORTFOLIOS, MARKET RISK AND CAPITAL MARKET LINE (CML):Market Risk & Portfolio Theory
  24. STOCK BETA, PORTFOLIO BETA AND INTRODUCTION TO SECURITY MARKET LINE:MARKET, Calculating Portfolio Beta
  25. STOCK BETAS &RISK, SML& RETURN AND STOCK PRICES IN EFFICIENT MARKS:Interpretation of Result
  26. SML GRAPH AND CAPITAL ASSET PRICING MODEL:NPV Calculations & Capital Budgeting
  27. RISK AND PORTFOLIO THEORY, CAPM, CRITICISM OF CAPM AND APPLICATION OF RISK THEORY:Think Out of the Box
  28. INTRODUCTION TO DEBT, EFFICIENT MARKETS AND COST OF CAPITAL:Real Assets Markets, Debt vs. Equity
  29. WEIGHTED AVERAGE COST OF CAPITAL (WACC):Summary of Formulas
  30. BUSINESS RISK FACED BY FIRM, OPERATING LEVERAGE, BREAK EVEN POINT& RETURN ON EQUITY
  31. OPERATING LEVERAGE, FINANCIAL LEVERAGE, ROE, BREAK EVEN POINT AND BUSINESS RISK
  32. FINANCIAL LEVERAGE AND CAPITAL STRUCTURE:Capital Structure Theory
  33. MODIFICATIONS IN MILLAR MODIGLIANI CAPITAL STRUCTURE THEORY:Modified MM - With Bankruptcy Cost
  34. APPLICATION OF MILLER MODIGLIANI AND OTHER CAPITAL STRUCTURE THEORIES:Problem of the theory
  35. NET INCOME AND TAX SHIELD APPROACHES TO WACC:Traditionalists -Real Markets Example
  36. MANAGEMENT OF CAPITAL STRUCTURE:Practical Capital Structure Management
  37. DIVIDEND PAYOUT:Other Factors Affecting Dividend Policy, Residual Dividend Model
  38. APPLICATION OF RESIDUAL DIVIDEND MODEL:Dividend Payout Procedure, Dividend Schemes for Optimizing Share Price
  39. WORKING CAPITAL MANAGEMENT:Impact of working capital on Firm Value, Monthly Cash Budget
  40. CASH MANAGEMENT AND WORKING CAPITAL FINANCING:Inventory Management, Accounts Receivables Management:
  41. SHORT TERM FINANCING, LONG TERM FINANCING AND LEASE FINANCING:
  42. LEASE FINANCING AND TYPES OF LEASE FINANCING:Sale & Lease-Back, Lease Analyses & Calculations
  43. MERGERS AND ACQUISITIONS:Leveraged Buy-Outs (LBO’s), Mergers - Good or Bad?
  44. INTERNATIONAL FINANCE (MULTINATIONAL FINANCE):Major Issues Faced by Multinationals
  45. FINAL REVIEW OF ENTIRE COURSE ON FINANCIAL MANAGEMENT:Financial Statements and Ratios