Corporate Finance Session 3 – Debt & Taxes
Exploring Debt, Tax Shields, implied Enterprise Value and Debt Overhang
Introducing the different frictions with respect to the Modigliani Miller theorem (cf.
Session 2) and hence the frictions that influence a company’s capital structure/the
reasons WHY capital structure matters = and here, because it affects your tax bill.
In most jurisdictions, interest expenses are considered a business expense > hence,
the net income will be reduced by them, and hence, tax will be lower than if you did
not have any interest expense (interest payments are « tax-deductible »)
That is not the case for dividends : they’re paid from after-tax income
As a company hence pays lower taxes when it has more debt, that incentivises debt!
Considering that the “size of the pie” in the MM framework is the value of BEFORE-TAX
cashflows, the Government becomes one of the stakeholders who gets a slice of the pie: the
bigger the debt slice, the smaller the Government slice… and the opposite for equity.
Debt eats into taxes when you issue debt (even if in a fair way as you pay a cost of debt)
Hence, the firm’s choice of capital affects the size of the Government’s slice, which will be
reduced by financing via debt instead of via equity.
/!\ What stays in the pocket of the company is long-term also belonging to the shareholders,
when they finally cash-out > hence they also have an incentive to make the company borrow
more, as opposed to letting more cash go to the Government in the form of taxes year after
year… Increased debt financing basically makes the Government the only loser here.
Example: XYZ Company, our equity financed company
Assuming an all-equity financed Co
- Constant cashflows going through time as a perpetuity (discount rate being a model
Risk-free rate at 10%)
- Taxes at 40% of EBIT
- Net Income = EBIT * (1-Tax Rate)
- Value of the company = value of its Equity = applying a perpetuity formula on the net
income cashflows
- Discount with the ACC (which is also the CoE as the company has no leverage – cf.
Session 2 of this course)
- Enterprise Value = Value of Equity = £120M in the medium scenario with EPS = £1.2
o This formula for EV is only applicable in this case, for a 100% equity company!
, Adding leverage
- Interest/coupon payments are 7% of the amount borrowed (£60M)
- Pre-tax income is (EBIT – Interest)
- Taxes are calculated on the pre-tax income
- Then only you get Net Income
- /!\ You still would have to add your change in Net Operating Assets to get the
Funding Surplus (remember? the money available to decision makers to allocate)
New definitions stemming from this example
(1) FCF = (here, in this example) post-tax EBIT = EBIT * (1- tax rate)
a. Would be NI if the company did not have any debt
(2) Tax shield = tax rate * interest payments = how much tax you save/don’t pay per
dollar of interest you pay => very important concept
(3) Capital Cash Flow = Sum of FCF and Tax shield [or Net Income + interest] [or EBIT –
amount of taxes paid out]
CCF (or “Total Cash Flow”) = cashflow that can be distributed to all investors (both
creditors & shareholders)
Exploring Debt, Tax Shields, implied Enterprise Value and Debt Overhang
Introducing the different frictions with respect to the Modigliani Miller theorem (cf.
Session 2) and hence the frictions that influence a company’s capital structure/the
reasons WHY capital structure matters = and here, because it affects your tax bill.
In most jurisdictions, interest expenses are considered a business expense > hence,
the net income will be reduced by them, and hence, tax will be lower than if you did
not have any interest expense (interest payments are « tax-deductible »)
That is not the case for dividends : they’re paid from after-tax income
As a company hence pays lower taxes when it has more debt, that incentivises debt!
Considering that the “size of the pie” in the MM framework is the value of BEFORE-TAX
cashflows, the Government becomes one of the stakeholders who gets a slice of the pie: the
bigger the debt slice, the smaller the Government slice… and the opposite for equity.
Debt eats into taxes when you issue debt (even if in a fair way as you pay a cost of debt)
Hence, the firm’s choice of capital affects the size of the Government’s slice, which will be
reduced by financing via debt instead of via equity.
/!\ What stays in the pocket of the company is long-term also belonging to the shareholders,
when they finally cash-out > hence they also have an incentive to make the company borrow
more, as opposed to letting more cash go to the Government in the form of taxes year after
year… Increased debt financing basically makes the Government the only loser here.
Example: XYZ Company, our equity financed company
Assuming an all-equity financed Co
- Constant cashflows going through time as a perpetuity (discount rate being a model
Risk-free rate at 10%)
- Taxes at 40% of EBIT
- Net Income = EBIT * (1-Tax Rate)
- Value of the company = value of its Equity = applying a perpetuity formula on the net
income cashflows
- Discount with the ACC (which is also the CoE as the company has no leverage – cf.
Session 2 of this course)
- Enterprise Value = Value of Equity = £120M in the medium scenario with EPS = £1.2
o This formula for EV is only applicable in this case, for a 100% equity company!
, Adding leverage
- Interest/coupon payments are 7% of the amount borrowed (£60M)
- Pre-tax income is (EBIT – Interest)
- Taxes are calculated on the pre-tax income
- Then only you get Net Income
- /!\ You still would have to add your change in Net Operating Assets to get the
Funding Surplus (remember? the money available to decision makers to allocate)
New definitions stemming from this example
(1) FCF = (here, in this example) post-tax EBIT = EBIT * (1- tax rate)
a. Would be NI if the company did not have any debt
(2) Tax shield = tax rate * interest payments = how much tax you save/don’t pay per
dollar of interest you pay => very important concept
(3) Capital Cash Flow = Sum of FCF and Tax shield [or Net Income + interest] [or EBIT –
amount of taxes paid out]
CCF (or “Total Cash Flow”) = cashflow that can be distributed to all investors (both
creditors & shareholders)
