A small note on MM Theory, unlevering-relevering and APV1

The essence of MM theory on capital structure (irrelevance) is that under certain

conditions, Vu = VL i.e. when the operational (and asset size) risk is the same, an
unlevered firm (a firm with no debt) and a levered (a firm with some debt) have the
same value in some conditions. How a firm’s assets are funded have no relevance in
value creation.

The moment taxes factor into the situation, the levered firm is more valuable than the
unlevered firm (other conditions remaining same) i.e. VL = VU + PVITS where ITS =
Interest Tax Shield i.e. the benefits of borrowing (firms that pay interest on debt have
reduced tax bill that retains as additional cash flow).

When a firm borrows, it either borrows with known debt value (in terms of currency)
or borrows with a debt to value ratio known. In both cases, the equations for risk and
returns are different. The following table provides the equations for various cases.

Debt Policy Equation for Risk & Reward Discounting rate

for ITS
Constant and 𝐷 Kd
𝑅𝑆 = 𝑅0 + × (1 − 𝑇𝐶 ) × (𝑅0 − 𝑘𝑑 )
perpetual debt 𝐸
𝐷
𝛽𝐸 = 𝛽𝐴 + × (1 − 𝑇𝐶 ) × (𝛽𝐴 − 𝛽𝐷 )
𝐸

Constant and finite Estimate the ITS at each period Kd

debt because $ debt is known but changes
every period.
Stable D/V (or D/E) 𝐷 R0
𝑅𝑆 = 𝑅0 + × (𝑅0 − 𝑘𝑑 )
𝐸
𝐷
𝛽𝐸 = 𝛽𝐴 + × (𝛽𝐴 − 𝛽𝐷 )
𝐸

1
I also thank all my colleagues who are co-teaching CF course currently whose inputs were imperative in
writing this note.
 APV

One of the applications of MM theory is in valuation, specifically in the APV method.

When MM theory is expanded to valuation, VL = VU + PVITS becomes

APV = NPVU + NPVF i.e. APV of a project (or firm) is the unlevered value of the project
(or firm) plus net effects of financing (PVITS – PVdebtcosts) where debtcosts here includes
all non-interest based costs of debt.

Let’s take the example done in class:

Gazinga! is considering a project to make wind mills. The wind mill project requires
an investment of $40 mn and offers a steady after-tax cash flow of $8 mn per year for
10 years. The required return on unlevered cash flows is 15%. Gazinga is going to
finance this project with a $25 mn debt issue that is privately placed. This debt issue
has an interest rate of 10%. The remaining $15 mn will be raised from equity capital.
The debt principal of $25 mn is to be paid back in ten equal installments. Assume the
marginal corporate tax rate as 25%, calculate the APV of the project.

What if the loan was structured in such a way that the principal was paid at the end
in a balloon payment? Compute APV

To solve this problem, we need two major inputs – NPVU and NPVF

NPVU = -40m + 8×PVIFA15%,10years = 0.15m (all cash flows discounted at R0 = 15%)

Next step is NPVF which in this case is merely PVITS because there are no non-interest
costs of debt.

In the first case, out of 40m investment, 25m is taken as a loan. This loan is now repaid
in 10 instalments where each instalment contains an equal payment of principal. This
essentially means the firm pays 2.5m as principal repayment each year. The interest
therefore will vary each year because the fundamentals of loan interest computation
is that the interest for any particular year (or period) is based on principal outstanding
at the beginning of the year (or period). Accordingly, the following table provides the
loan schedule, based on which we estimate interest paid and the ITS each year which
is nothing but interest (in $)×tax rate. At a tax rate of 25%, the table provides details
of interest and ITS
 Time CF Principal at beginning Interest ITS
0 -40 25
1 8 22.5 2.5 0.625
2 8 20 2.25 0.5625
3 8 17.5 2 0.5
4 8 15 1.75 0.4375
5 8 12.5 1.5 0.375
6 8 10 1.25 0.3125
7 8 7.5 1 0.25
8 8 5 0.75 0.1875
9 8 2.5 0.5 0.125
10 8 0 0.25 0.0625

Now that we have this data, as the dollar value of debt is known (note, the known
debt does not imply same debt, it is just that the value is known in advance),
discounting rate for ITS is kd which in this case is 10%. Discounting each year’s ITS
with 10%, NPVF = PVITS = 2.41m. Therefore, APV = 0.15+2.41 = ₹ 2.56m.

Let’s look at case B where the loan of 25 million is a balloon payment. The difference
here is that there is no principal repayment during the 10 years, but only interest is
paid. The entire principal is therefore repaid in one full bulk at the end of 10 years.
Therefore, the schedule will look like this:

Principal at
Time CF Interest ITS
beginning
0 -40 25
1 8 25 2.5 0.625
2 8 25 2.5 0.625
3 8 25 2.5 0.625
4 8 25 2.5 0.625
5 8 25 2.5 0.625
6 8 25 2.5 0.625
7 8 25 2.5 0.625
8 8 25 2.5 0.625
9 8 25 2.5 0.625
10 8 0 2.5 0.625

The PV of ITS will be discounted using kd. PVITS = 0.625×PVIFA10%,10 years = 3.84m.

An alternate way to do this is to find the NPV of the loan which is

 25
25-0.1×25×(1-0.25)×PVIFA10%,10 years-1.110 = 3.84m.

You will notice that both the approaches provide the same answer (it has to!!!!).
Essentially, in approach one, the benefits of borrowing was directly estimated using
the PV of ITS. In approach two, the benefits of borrowing was indirectly estimated
using the money saved through the loan (without interest shield PV of a loan is always
0, the benefit arises only because of the interest tax shield).

APV = 0.15+3.84=3.99m

Note: You will notice that when balloon payment is the method, PV of ITS is higher,
this describes the time value principle, later you repay the principal, more you benefit
by time value.

As a rule of thumb, to solve APV problems, following conceptual clarity is needed

1. Estimation of NPVU – for this you need after tax cash flows and R0
2. Estimation of NPVF – for this you need to estimate ITS based-on scenario and
determine which discounting rate to use (kd or R0)