Complete The Following Textbook Questions Chapter 21 Questio

Complete The Following Textbook Questionschapter 21 Questions 21 1 A

Complete the following textbook questions: Chapter 21: Questions 21-1 and 21-2 on page 868; Chapter 21: Mini-case on page 871 (complete parts A through E).

(21-1) • (21-2) • Mini Case David Lyons, CEO of Lyons Solar Technologies, is concerned about his firm’s level of debt financing. The company uses short-term debt to finance its temporary working capital needs, but it does not use any permanent (long-term) debt. Other solar technology companies average about 30% debt, and Mr. Lyons wonders why they use so much more debt and how it affects stock prices. To gain some insights, he poses the following questions to you, his recently hired assistant.

a. Who were Modigliani and Miller (MM), and what assumptions are embedded in the MM and Miller models?

b. Assume that Firms U and L are in the same risk class and both have EBIT = $500,000. Firm U uses no debt, and its cost of equity is r_{s U} = 14%. Firm L has $1 million of debt at r_d = 8%. No taxes are assumed. Under the MM assumptions,:

• 1. Find V, S, r_s, and WACC for Firms U and L.
• 2. Graph (a) the relationship between capital costs and leverage D/V and (b) the relationship between V and D.

c. Now assume both firms are subject to a 40% corporate tax rate. Repeat the analysis from b(1) and b(2) using assumptions from the MM model with taxes.

d. Suppose Firms U and L grow at 7% annually, with investments in net operating assets equal to 10% of EBIT. Use the compressed adjusted present value (APV) model to estimate the value of U and L, including their levered cost of equity and WACC.

e. With an expected Year 1 free cash flow (FCF) of $250,000, growing unevenly over three years ($290,000 in Year 2 and $320,000 in Year 3), and thereafter at 7%, with interest expenses of $80,000 initially, growing to $95,000 at Year 2, and $120,000 at Year 3, what is the horizon unlevered value of operations?

Define the following terms:

1. Interest tax shields and the value of the tax shield
2. Adjusted present value (APV) model
3. Compressed adjusted present value (CAPV) model

How does positive growth alter MM's conclusions about the value of a leveraged firm and its cost of capital? What is the current unlevered value of operations? The horizon value of the tax shield at Year 3? The current value of the tax shield? And the total current value? Assume a 40% tax rate and unlevered cost of equity of 14%.

Paper For Above instruction

The theories developed by Franco Modigliani and Merton Miller (MM) fundamentally revolutionized our understanding of corporate finance. Their models, especially the propositions regarding capital structure, suggest that under certain idealized conditions, a firm's value is unaffected by how it is financed. Their groundbreaking assumptions included no taxes, no bankruptcy costs, perfect markets, and no growth, which allowed them to derive elegant results about the irrelevance of leverage in firm valuation. Yet, real-world complexities necessitate adjustments to these models, notably incorporating corporate taxes and growth opportunities which significantly influence firm valuation and optimal capital structure strategies.

Modigliani and Miller's original frameworks rest on several pivotal assumptions: perfect capital markets with no taxes, no bankruptcy or agency costs, and no growth (zero-growth environment). Under these conditions, the value of a leveraged firm equals that of an unleveraged firm because the tax shield benefits of debt are precisely offset by increased bankruptcy risk and agency costs. However, their assumptions are idealized; in practice, taxes play a profound role. When corporate taxes are introduced, debt financing becomes advantageous due to tax shields that enhance firm value. This is because interest is tax-deductible, reducing taxable income and thereby creating additional value—an insight captured in their proposition that leverage can increase firm valuation in tax environments.

The Capital Asset Pricing Model (CAPM) forms the foundation for understanding how leverage affects the cost of equity. As firms increase leverage, their equity becomes riskier, leading to a higher equity cost of capital. The relationship between leverage (D/V) and the cost of equity (r_s) is typically upward sloping, reflecting greater risk borne by shareholders. Conversely, the weighted average cost of capital (WACC) initially decreases with leverage due to the tax shield's effect until the cost of debt exceeds its benefit, beyond which it may rise. Graphically, the cost of equity amplifies with increasing leverage, whereas WACC tends to decline initially and then stabilize or increase depending on market conditions.

The Modigliani-Miller model with taxes implies that the value of a leveraged firm increases linearly with its debt level due to the present value of tax shields. The firm's total value (V) under debt includes the unleveraged value plus the present value of tax shields. The value of the tax shield hinges on the tax rate and the amount of debt and can be calculated as D multiplied by the tax rate, discounted at the cost of debt, often assumed to be r_d under MM assumptions. These valuation effects are captured elegantly by the Adjusted Present Value (APV) approach, which separates the value of operating assets from financing side effects.

The growth considerations alter MM’s conclusions by introducing the value of future investment opportunities and reinvestment potential, which are ignored in the zero-growth assumptions. When a firm grows, its future cash flows increase, and the valuation must incorporate this growth, often via discounted cash flow (DCF) methodologies. The presence of growth modifies the firm's leverage and tax shield benefits, potentially increasing its overall value. The horizon unlevered value of operations is computed considering both the current cash flows and the expected growth rate, while the value of tax shields must also factor in the growth potential, affecting the current and future valuation metrics.

Estimating the unlevered value of operations involves discounting expected future free cash flows at the unlevered cost of capital, adjusted for growth. The horizon value of the tax shield at Year 3 considers the present value of future tax savings resulting from debt, often calculated by projecting the tax shield's growth in perpetuity. The total current value combines the unlevered operations’ present value with the present value of the tax shields, adjusted for growth, taxes, and risk parameters prevalent in the firm's structure.

In light of these principles, strategic leverage decisions require understanding the complex interplay between taxes, growth, risk, and market conditions. While MM’s irrelevance theory holds in idealized environments, real-world application must account for taxes and growth, which tend to favor higher leverage due to the tax shield benefits, although practical considerations such as bankruptcy risk impose limits. These models serve as vital benchmarks for analyzing corporate financing decisions, ensuring that firms balance the benefits of debt against potential costs, ultimately aiming to maximize firm value within their operational and market constraints.