FIRM VALUATION
WITH TAXES
Firm Valuation with
Corporate Taxes
Assumptions:
Only corporate taxes - individual tax rate is
zero
Capital markets are frictionless
Individuals can borrow and lend at the risk-free
rate
There are no costs to bankruptcy
Firms issue only two types of claims: risk-
free debt & (risky) equity
All firms are in the same risk class
CFi CFj
No other taxes than corporate taxes
All cash flow streams are perpetuities
Everybody has the same information
No agency costs
The P/L statement
Let
NOI = Net Operating Income
t = tax rate
D = outstanding debt
r = interest rate
P = net profit
= return requirement on equity
Assume first that D=0. Then P = NOI-t*NOI= NOI*(1-t)
The value of the firm’s equity - under the going concern
assumption - is equal to the value of the firm:
E U = V U =P/ NOI*(1-t) /
The P/L statement
Assume next that D>0.
Then P = NOI-rD-t*(NOI-rD)= (NOI-rD)*(1-t)
The firm now has to yield profits to cover both return on
equity and interest on loans. The value of the firm’s equity
- under the going concern assumption – is
E L = NOI*(1-t)/ rD(1-t)/r = E U - D(1-t), from which
E U = V U = E L +D(1-t) = E L + D – Dt.
But V L = E L + D by definition. Thus,
V U = V L – Dt. Notice that if t=0, then
V U = V L (the famous Modigliani-Miller theorem)
The Modigliani-Miller theorem implies that
“The market value of any firm is independent
of its capital structure and is given by
capitalizing its expected return at the rate
appropriate to its risk class”
(Modigliani-Miller, American Economic Review, 1958 june)
Hamada’s equation
The beta of a firm i – obtained from ordinary least squares
regression – is: βi cov(r i ,rM )/var(r M ) (1)
From the discussion above, we know that the return on
equity for a firm without debt – an unlevered firm – is
rU = NOI*(1-t)/EU (2)
and for a firm having debt – a levered firm – is
rL = (NOI-rD)*(1-t)/EL. (3)
Inserting (2) and (3) in (1) gives the betas of the
unlevered and levered firms:
Hamada’s equation
cov(NOI(1 - t)/E U ,rM ) cov(NOI(1 - t), rM )
βU E Uβ U
var(r M ) var(r M )
and
cov((NOI - rD)(1 - t)/E U ,rM )
βL
var(r M )
cov(NOI(1 - t), rM ) cov(rD(1 - t), rM )
EL βL
var(r M ) var(r M )
Hamada’s equation
By elementary covariance rules, cov(x+y,z) =
cov(xz)+cov(yz), giving the expression for L.
Furthermore, since the interest rate is assumed to be
nonstochastic, the latter term in the expression for L is
zero. Therefore,
cov(NOI(1 - t), rM )
ELβL E Uβ U
var(r M )
E Uβ U
βL
EL
Hamada’s equation
We showed above that E U = E L + D – Dt.
Inserting this in the expression for beta of the levered firm
gives the well-known Hamada’s equation [1972], combining
the Modigliani-Miller theorem with the Capital Asset Pricing
Model (CAPM):
E Uβ U (E L D - Dt)βU D
βL (1 (1 t ))βU
EL EL EL
Assume that the firm’s debt (D) equals
the market value of the debt (B).
When the firm makes an
investment I, its value will change
according to (C-W, p. 445)
L
V (1 t c ) E ( NOI ) B
tc
I I I
The above investment will affect the
value of the levered firm:
L 0 n 0 n
V S S B B
0 n
Note that Equity = old + S + S
Because the project has the same risk
as those already outstanding, the value
of the outstanding debt stays the same
( B 0 0) .
Because the new project is financed with
new debt, equity or both
n n
I S B
Inserting I into the above formula,
L 0 n n
V S S B
I I I
L 0
V S
1
I I
This means that the project has to
increase the shareholders’ wealth, so
that
0 L
S V
1 0
I I
L 0
V and
S
1 0
I I
The Weighted Average Cost of Capital
(Copeland-Weston, 1988, p. 444)
• IAS 36.55: the discount rate should be the pre-tax
rate that reflects current market assessments of the
time value of money and the risks specific to the
asset
• IAS 36.57: If market-determined discount rates are
unavailable, one should recognize the entity’s:
• weighted average cost of capital
• the incremental borrowing rate
• other market borrowing rates
The Weighted Average Cost of Capital
(Copeland-Weston, 1988, p. 444)
Recall the formula
L n
V (1 t c ) E(NOI) B
tc 1
I I I
as shown it should be greater than 1, so
(1 t c ) E(NOI) B
(1 t c )
I I
This results in what is called “the Weighted
Average Cost of Capital”, WACC,(C-W, p.446).
B
WACC 1 tc
I
If there are no taxes the cost of capital is
independent of capital structure.
B
What does mean ?
I
B*
“IfV* denotes the firm’s long run target
debt ratio ... then the firm can assume,
that for any particular investment
dB B * “
dI V * (C-W, p. 446).
An alternative definition of the
weighted average cost of capital
Definition by Haley and Shall [1973]
Target leverage ratio
B
WACC 1 tc
V
Reproduction
value
Reproduction value = PV of the stream of goods
and services expected from the project.
How to calculate the cost of the two
components in WACC (debt & equity)
Assumptions:
The cost of debt = k b
The cost of equity capital is the return on
0 n
S S
NI
0 n
S S
This can be written as (C-W, p. 449):
NI B
0 n
(1 t c )( kb )
S S S0 Sn
Since the total change in equity is
0 n
S S S
NI
, the cost of equity ks
S
can be written as
B
ks (1 t c )( kb )
S
If the firm has no debt in its capital
structure, then k s
It can be shown that (C-W, p. 451) WACC
can be written as:
B S
WACC (1 t c )k b ks
B S B S
tax shield Percentage Percentage
cost of debt in cost of equity in
of debt the capital of equity the capital
structure structure
This formula is the same as the
Modigliani-Miller definition
B
WACC 1 tc
B S
The M-M and the traditional definition
are identical !
Combining cost of equity equations :
B
Rf [E (Rm ) Rf ] L ( kb )(1 c)
S
Cost of equity (CAPM) Cost of equity (MM)
Then substituting the CAPM definition of
unlevered , rearranging and canceling terms...
B
[E (Rm ) Rf ] L [E (Rm ) Rf ] 1 (1 c) U
S
If we can observe L by using observed
rates of return on equity in the stock
market, then we can also estimate U of
the firms operating cash flows.
In absence of bankruptcy costs, it
doesn’t matter if the debt is risky or not,
L L U
V
the is still the same (V V t c B) .
C-W, 1988, p. 457.
Valuing the Equity of a Firm with the
B & S Option Pricing Model (OPM)
The equity of a firm can be seen as a call
option.
It is possible to apply the Black &
Scholes OPM on the valuation problem.
rf T
S VN( d1 ) e DN( d2 )
ln( V / B) rf T 1
d1 T d2 d1 T
T 2
C-W, p. 467.
,where
S = The market value of equity
V = The market value of the firm’s assets
rf = The risk-free rate
T = The time to maturity
B = The face value of debt (book value)
N(.) = The cumulative normal probability of
the unit normal variate, d1
= The standard deviation of the returns
on the firm’s assets
Measuring risk (beta) with the OPM
S= Systematic risk of equity
V = Systematic risk of the firm’s assets
V = Market value of the firm’s assets
S = Market value of equity
(according to Black & Scholes)
V
S N(d1 ) V
S
By substituting the above formula for S,
we get
VN ( d1 )
s = rf T v
VN ( d1 ) Be N( d2 )
1
= rf T v
1 ( B / V )e [ N ( d 2 ) / N ( d1 )]
The impact of parameters on S
on equity increases monotonically
with leverage.
Increasing
parameter S
Market value (V)
Debt (B)
Risk-free rate (rf )
Variance of the firm’s
assets’ value (
Maturity of debt (T) C-W, p. 467.
The cost of debt funding (C-W, p. 469).
According to the OPM k B is
V
kB rf ( rf ) N( d1 )
B
Risk premium
The OPM, CAPM & M-M are all consistent,
when there exist no bankruptcy costs!
C-W, p. 471.
Literature
Copeland T.E, Weston I.F (1988): Financial Theory
and Corporate Policy. Addison-Wesley. New York.
Goetzmann, William (2000): An introduction to
investment theory. Available on
http://viking.som.yale.edu/will/web_pages/will/finman5
40/classnotes/notes.html
Hamada, R.S. (1972) “The Effect of the Firm's Capital
Structure on the Systematic Risk of Common Stocks,”
The Journal of Finance, 27(2):435-452.
Keeping all options open (1999). The economist
08/17/99
Johnson, Richard A & Wichern, Dean W (1997).
Business Statistics: decision making with data. Wiley.
