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Effectiveness of financial leverage
An introduction to debt policy excel
Merton theory
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Introduction
Motivation and background
Decisions about optimizing the capital structure of the firm, no matter if it is a small business or a global corporation, has always been an important issue for the management.
Various authors, (e.g. Booth (2002), Cooper and Nyborg (2006), Farber, Gillet and Szafarz (2006)) state that debt policy may only be viewed in terms of maintaining a fixed market value debt ratio (Miles-Ezzell assumption) or a fixed dollar amount of debt (Modigliani-Miller assumption).
The presence of debt financing increases the total cash flow available to debt and equity claimants, as the tax system in most countries allows interest costs to be tax deductible. As a consequence, a levered firm pays less in taxes than does a pure-equity firm, and the sum of the debt plus the equity of the levered firm must be greater than the sole equity of the unlevered firm. The value of the tax shield of debt has gained considerable attention in recent years in real world applications as well as in the academic literature.
The tax shield from debt represents a significant proportion of total value for many companies, projects, and transactions. Its potential size can be seen by considering a company with a 30% debt-to-capital ratio and a corporate tax rate of 40%. One approach to valuing the debt tax shield is simply to multiply the amount of debt by the tax rate, in which case the debt tax shield would be seen as contributing 12% of total value (Cooper, Nyborg 2007). And if the leverage ratio were doubled, the debt tax shield could be shown to contribute almost a quarter of the value of the company. Accurate valuation of the debt tax shield is of more importance than ever as leverage is now commonly used as a source of value add...
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...view 48: 261-297.
Modigliani, Franco and Miller, Merton H. 1963. Corporate income taxes and the cost of capital: A correction. American Economic Review 53: 433-443.
Myers, Stewart C. 1977. Determinants of corporate borrowing. Journal of Financial Economics 5: 146-175.
Myers, Stewart C. 1984. The capital structure puzzle. Journal of Finance 39: 575-592. Newbould, Gerald N., Robert E. Chatfield and Ronald F. Anderson. 1992. Leveraged buyouts and tax incentives. Financial Management 21: 50-57.
Ruback, Richard S. 1995. A note on capital cash flow valuation. Harvard Business School Case No. 9-295-069.
Ruback, Richard S. 2002. Capital cash flows: A simple approach to valuing risky cash flows. Financial Management 31: 85-103.
Theis C. 2009 “What is the Value of the Tax Shield of Debt?”
Q-finance journal. 2013 “Understanding Capital Structure Theory: Modigliani and Miller”
The EAR (6.6%) can deal with debts of different payment frequencies. Nonetheless, nominal rates should be used because the total costs, which are naturally small on public debt issues, decrease the net proceeds from the sale.
Earlier 2002, the stock price of Agnico-Eagle Mines sharply decreased by $1 finally closed at $13.89. This price has reached one of the lowest level, from the company's historical perspective. As a professional equity portfolio manager, who has a large number of AEM stocks on hand. Acker and his team are necessary to find a proper way to estimated the fair value of AEM as well as its equity. Discounted Cash Flow (DCF) has been chosen to do this job. The theory behind DCF valuation approach is that the firm's value can be estimated by using the expected future free cash flow discounted by an appropriate discounted rate (Koller etc 2005). However several assumptions need to be clearly examined within this approach. The following sections are showing the process of DCF step by step.
Gaughan, P. A., 2002. Mergers, Acquisitions, and Corporate restructuring. 3rd ed.New York: John Wiley & Sons, Inc.
... Capital, Corporation Finance and the Theory of Investment", The American Economic Review, vol. 48, no. 3, pp. 261-297.
Discounted Cash Flow Method takes the forecast free cash flows during forecasted horizon. Then we estimate the cost of capital (weighted average cost of capital) and estimate continuing value (value after forecast horizon). The future value is discounted to the present value. We than add back cash ($13 Million) and non-current assets and deduct total debt. With the information provided several assumptions had to be made to obtain reasonable values (life period of 30-years, Capital expenditures not to exceed $1 million dollars, depreciation to stay constant at $1.15 Million and a discounted rate of 10%). Based on our analysis, the company has a stand-alone value of $51 Million at the end of fiscal year end 1990 with a net present value of cash flows of $33 million that does not include the cash and non-current assets a cash of and non-current assets.
Discounted cash flow is a valuation technique that discounts projected cash inflows and outflows to evaluate the potential value of an investment. There are three discounted cash flow methods: Net Present Value (NPV), Profitability Index (PI) and Internal Rate of Return (IRR). The net present value discounts all cash inflows and outflows at a minimum rate of return, which is usually the cost of capital. The profitability index refers to the ratio of the present value of cash inflow to the present value of cash outflows. The internal rate of return refers to the interest rate that discounts cash inflow projections to the present to ensure that the present value of cash inflows is equivalent to the present value of cash outflows (Brown, 1992).
The results obtained from the cooperation of Modigliani and Miller in 1958, was an attempt to prove that the financial decisions should not be significant in the perfect conditions of the market, after being published the Modigliani and Miller theory became the main theory of the capital structure. In the M&M theory it suggested that the market is fully efficient, meaning that there are no taxes, however in the theory Modigliani and Miller included the taxes to be able to reflect their theories in reality, and the theory also suggested that there are no bankruptcy costs. There are three propositions that were published by Modigliani and Miller which are: • Proposition 1: A firm’s total market value is independent of its capital structure. Proposition 2: The cost of equity increases with its debt-equity ratio. Proposition 3: A firm’s total market value is independent of its dividend policy.
Scholastic Company is a multibillion dollar children’s book publisher and distributor with more than 9,000 worldwide employees (Scholastic Inc., n.d.). Scholastic leases some of its physical office and storage locations and equipment (as cited in Gibson, 2011). Cornaggia, Franzen, and Simin (2013) noted the reasons firms lease may be the result of a company’s financial distress which prevents sufficient capital being raised to purchase instead of leasing. They also suggested if profitability of the firm is not at issue, leasing can be used to reduce taxes thus reducing borrowing costs. Though the reason for maintaining material lease obligations is not disclosed in its financial statements (as cited in Gibson, 2011), Scholastic’s ability to satisfy its long-term commitments is important for investors, creditors, and management. The long-term borrowing capacity of Scholastic can be determined through an analysis of its times interest earned, fixed charge coverage, and debt ratios.
Higher leverage is very likely to create value for a firm considering capital structure change by exerting financial discipline and more efficient corporate strategy changes.
Berk, J., & DeMarzo, P. (2011). Corporate finance: The core, second edition. (2nd ed.). Boston, MA: Prentice Hall.
Brealey, Richard A., Marcus, Alan J., Myers, Stewart C. 1999, Fundamentals of Corporate Finance, 2nd edn, Craig S. Beytien, USA.
Week 5 Lecture. (2006). FIN 325 Mergers, Acquisitions, and International Finance. Retrieved from rEsource on July 7th, 2006 from https://ecampus.phoenix.edu/secure/resource/resource.asp
Modigliani & Miller, M&M, (1958) found that in a world without taxes, the value of the firm is not affected by its capital structure, and also that the total return to investors remains the same regardless. M&M showed the
Block, S. B., & Hirt, G. A. (2005). Foundations of financial management. (11th ed.). New York: McGraw-Hill.
a. 1. What sources of capital should be included when you estimate Harry Davis’s weighted average cost of capital (WACC)?