

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
Unlevered) 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)
(1TC)
WACCL =
rD(1Tc)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 Yaxis 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 Markup
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 UnLevered) and rE =
20% then what is the
WACCU
of
Unlevered
Firm?
·
Net
Income = EBIT  Interest 
Tax
=
100  0  0.3(100)
=
Rs.70
·
Market
Value of Unlevered Equity =
Eu
=
NI / rE
=
70 / 0.2
=
Rs.350
·
Market
Value of Unlevered Firm =
Vu
=
Equity + Debt
=
350 + 0
=
Rs.350
·
WACC
u = rE,U
=
20%
If
the Firm takes Rs.100 Debt
at 10% Interest or Markup
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 (1Tc) xD
+ rE,LxE
=
0.1(10.3) (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 UnLevered 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(1Tc) xD +
rE,LxE
Note: WACCL =WACCU (1Tc)
xD
·
Use
Either NI Approach or Tax
Shield Approach depending on
what Data has been given to
you.
Other
Shortcut Formulas & Link
between Capital Structure &
Betas
·
Cost of Equity (After
Tax) Estimates and STOCK
BETAS
rE,L = WACCU
+ xD (WACCU
rD)
(1Tc)
rE,L = rE,U +
Debt/Equity (rE,U rD)
(1Tc)
rE,U = rRF
+
BETAE
( rM 
rRF )
Recall
from CAPM Theory
·
WACC (After Tax)
Estimates AND FIRM
BETA
WACCL = rD,L(1Tc)xD + rE,LxE
WACCL = rRF
+
BETAWACC,L (
rM  rRF
)
Note:
Overall Beta for the
Firm
=
BETAWACC,L = BetaD
xD +
BetaE xE
153
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