Miller Modigliani
Capital Structure With or Without Taxes
No Taxes Tax Rate
Starting numbers 0% 30%
Debt 0 2500
Equity 5000 3250
Firm Value 5000 5750
# Shares 200 113.04
Share price 25 28.75
28.75
Announcement
Debt Announced 2500
Tax Shield 750 Market understands and computes it
New Firm Value 5750 Equity prices immediately adjust. Equity gets
Old Share Price 25 Cell C22
New Share Price 28.75 Old value + Tax Shield per share
When Debt Is Issued Non-event for shares as prices already adjust
Debt Issue 2500
Equity Repurchased 2500
# Shares Bought Back 86.96
# Shares Left 113.04
Value of Remaining Shares 3250
Notes I don't
Formula for PV (Tax Shield) = D*Tc = Debt Amount * Corporate Tax Rate. Valid for perpetu
Derivation
If you issue Debt D at rate r_d, your annual interest expense is D*r_d to perpetuity
The tax shield this generates is D*r_d*Tc each year
PV (perpetuity of D*r_d*Tc) = D*r_d*Tc/r_d = D*Tc (PV perpetuity of cashflow F each year d
Additional Note
If debt is not perpetual, or tax shield is not constant, the formula D*Tc is not correct.
Recompute the result and plug the answer into G7
d computes it
ely adjust. Equity gets tax shield benefit
per share
s prices already adjusted!
ate. Valid for perpetual debt
perpetuity
ashflow F each year discounted at r = F/r)
is not correct.
Common Doubts
1) Debt Reduces Cash flows to equity. How come equity prices increase?
Correct.
-- Debt reduces future cash flows to equity.
-- But when debt is issued, there is a recapitalization, i.e., capital structur
-- When you factor in the distribution received by equity in the recapitaliz
2) If issuing debt increases value, issuing debt must be increasing cash flows.
Sure. In the below example, we will show that a 100% equity firm returns LES
-- Consider a firm making $10 per year and paying income taxes @30%.
-- The only cash flow paid out is to equity holders. This is $10*(1-30%) = $
-- Now suppose the firm issues debt of $50 at cost 5% (and uses debt pro
-- The firm makes two payments to its liabilities -- interest to debt holder
-- The annual interest payment = $50*5% = $2.5 per year
-- The annual payments to equity = $(10-2.5)*(1-30%) = $5.25
-- Total cash flow to equity and debt = $5.25+$2.5 = $7.75
-- Thus, the levered firm with debt returns more to its liabilities in the agg
3) In the above example (2), debt creates a tax shield. Can you show how to
-- The textbook way of looking at it is tax shield = interest * tax rate = $2.5
-- Another fully equivalent way is to look at total cash flow paid out to all
-> $7.75 (row 21) - $7 (row 15) = $0.75 per year. Same answer
-- A third way of looking at it is to compute the tax paid by the 100% equi
-- The 100% equity firm pays $10*30% = $3 per year
-- The levered firm pays (10-2.5)*30% = $2.25 per year (interest is dedu
-- The difference in tax bill = $3 - $2.25 = $0.75
ity prices increase?
on, i.e., capital structure is changed. Debt replaces equity, i.e., equity holders get a distribution = debt proce
equity in the recapitalization, equity comes out ahead
e increasing cash flows. Can you give an example?
equity firm returns LESS to its financiers. A firm with some debt returns MORE to its financiers.
income taxes @30%.
This is $10*(1-30%) = $7 per year
5% (and uses debt proceeds to buy back equity, the usual recapitalization)
interest to debt holders and whatever is left out to equityholders
5 per year
-30%) = $5.25
o its liabilities in the aggregate.
Can you show how to compute it?
nterest * tax rate = $2.5 (row 19)*30% = $0.75 per year
ash flow paid out to all liabilities by levered firm minus total cash flow to all liabilities paid by the 100% equit
. Same answer
x paid by the 100% equity firm and the tax paid by the levered firm.
er year (interest is deductible, so the firm pays taxes on income after taking interest deduction)
stribution = debt proceeds
financiers.
paid by the 100% equity firm
deduction)
