# Financial Management

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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
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
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
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