Unleverd firm: all-equity, no debt

Levered firm: there is some debt

EPS: Earnings per share

EPS = Net income / Number of shares outstanding

ROE: Return on equity

ROE = Net income / Total equity

ROA: Return on asset

ROA = Net income / Total assets

Break-even point is the EBIT that makes EPS (current CS,

no debt) = EPS (proposed CS, with debt)
EBIT/number of shares outstanding under current CS
= (EBIT – Interest) / number of shares outstanding under
proposed CS
EBIT / 400 = (EBIT – 640) / 240
 EBIT = $1,600: break-even EBIT
If we expect EBIT less than the break-even EBIT (bad
time), should not use debt (leverage).
If we expect EBIT greater than the break-even EBIT (good
time), should use debt (leverage).

M&M proposition I is about firm value

M&M proposition II is about cost of capital (cost of
levered equity RS, cost of capital RWACC)

Slide 17: Value of a levered firm (with taxes)

VL = VU + BTc
where: VU = EBIT(1-Tc) / R0

Proof:
With taxes, interest expense on debt is tax deductible.
Therefore, firm value increases when firm uses debt.

The tax saving is: BRBTc : interest tax shield

Assume perpetual cash flow. The present value of
interest tax shield: BRBTc / RB = BTc
Conclusion: With taxes, the value of a levered firm
increases by the present value of interest tax shield. This
is the M&M proposition I (with taxes).

No taxes:
Cost of capital (WACC) in a levered firm:

B S
RW ACC = ´ RB + ´ R S
B + S B + S
where RS (cost of equity in a levered firm) is
calculated using formula in slide 14
Cost of capital (WACC) in an all-equity firm:
RWACC = R0

With taxes:
Cost of capital (WACC) in a levered firm:
B SL
RW ACC = ´ R B ´ (1 - T C ) + ´ R S
B + S L B + SL
where RS (cost of equity in a levered firm) is
calculated using formula in slide 17