Valuation with Taxes: WACC Approach In contrast to a world with no taxes, in Table 3 we now consider the more realistic case where the firm pays taxes, and interest payments are tax deductible. Assume that the tax rate, as in the first calculations, is equal to 30%. Table 3. Tax rate equals 30% Debt= $380,000 No Debt EBIT 104,000 104,000 31,200 31,200 NOPAT 72,800 72,800 Change in net PPE 0 0 Change in NWC 0 0 Free cash flow 72,800 72,800 Unleveraged beta 0.80 0.80 Proportion of debt 0.00 0.46683 Debt to equity 0.00 Leveraged beta 0.80 Cost of equity (use CAPM) WACC Enterprise value Difference in enterprise values Calculate ratio of debt to enterprise value The results above regarding the enterprise values are quite different from those in a world with no taxes. Provide an intuitive explanation for the results. the resulting changes in equity cash flows, it is clear that the existence of debt financing magnifies changes in equity cash flows. As you might expect, this variation also influences thee beta of a firm's equity. In fact, we can describe that effect with Equation 1, which you will use for the remainder of these calculations BL-Bux (1+(1-) xD+ E) (1) where Bi is the leveraged beta (beta given debt financing), Bu is the unleveraged beta (beta of firm without debt, also called an asset beta), t is the marginal corporate tax rate, D is the market value of debt, and E is the market value of equity. Valuation without Taxes: Weighted Average Cost of Capital (WACC) Approach To better understand the effects of debt, which are related to the existence of tax deductibility, it is useful to first consider a world with a zero marginal tax rate. The usual formulas still apply, but the tax rate is set to zero. We will assume that given the risks of our simple firm and assuming the firm was entirely financed with equity, the beta of the equity would equal 0.80. This is the unleveraged beta referred to in Equation 1. Furthermore, we will assume the risk-free rate of return is equal to 6.0 %. This is the same as the interest rate on debt, which implies that the debt is riskless. Finally, assume that the market risk premium is equal to 5.5% Fill out the Table 2 assuming first that there is no-debt and then assuming debt, as described earlier, equal to $380,000. We will value the company using the WACC approach- discounting free cash flow by the WACC. To do this, you must have a measure of the proportion of debt financing based on market values, but the firm's market value (enterprise value) is unknown. A proportion is assumed below, and you will verify it is consistent with the results. You will also calculate the difference in enterprise values between the Debt and No Debt cases. Valuation with Taxes: WACC Approach In contrast to a world with no taxes, in Table 3 we now consider the more realistic case where the firm pays taxes, and interest payments are tax deductible. Assume that the tax rate, as in the first calculations, is equal to 30%. Table 3. Tax rate equals 30% Debt= $380,000 No Debt EBIT 104,000 104,000 31,200 31,200 NOPAT 72,800 72,800 Change in net PPE 0 0 Change in NWC 0 0 Free cash flow 72,800 72,800 Unleveraged beta 0.80 0.80 Proportion of debt 0.00 0.46683 Debt to equity 0.00 Leveraged beta 0.80 Cost of equity (use CAPM) WACC Enterprise value Difference in enterprise values Calculate ratio of debt to enterprise value The results above regarding the enterprise values are quite different from those in a world with no taxes. Provide an intuitive explanation for the results. the resulting changes in equity cash flows, it is clear that the existence of debt financing magnifies changes in equity cash flows. As you might expect, this variation also influences thee beta of a firm's equity. In fact, we can describe that effect with Equation 1, which you will use for the remainder of these calculations BL-Bux (1+(1-) xD+ E) (1) where Bi is the leveraged beta (beta given debt financing), Bu is the unleveraged beta (beta of firm without debt, also called an asset beta), t is the marginal corporate tax rate, D is the market value of debt, and E is the market value of equity. Valuation without Taxes: Weighted Average Cost of Capital (WACC) Approach To better understand the effects of debt, which are related to the existence of tax deductibility, it is useful to first consider a world with a zero marginal tax rate. The usual formulas still apply, but the tax rate is set to zero. We will assume that given the risks of our simple firm and assuming the firm was entirely financed with equity, the beta of the equity would equal 0.80. This is the unleveraged beta referred to in Equation 1. Furthermore, we will assume the risk-free rate of return is equal to 6.0 %. This is the same as the interest rate on debt, which implies that the debt is riskless. Finally, assume that the market risk premium is equal to 5.5% Fill out the Table 2 assuming first that there is no-debt and then assuming debt, as described earlier, equal to $380,000. We will value the company using the WACC approach- discounting free cash flow by the WACC. To do this, you must have a measure of the proportion of debt financing based on market values, but the firm's market value (enterprise value) is unknown. A proportion is assumed below, and you will verify it is consistent with the results. You will also calculate the difference in enterprise values between the Debt and No Debt cases