Financial models

  1. According to Modigliani & Miller (MM) in a tax world the value of the company increases when a company is leveraged. The increase in the observed value should be, depending on the way value the firm, the impact of the tax savings of the interest or to the continued decline in the WACC (discount rate)
  2. From the above, it could be deduced that if shareholders want to increase the value of the firm, all they have to do is take on increasing levels of debt.
  3. However, this is not so basically for two reasons. The first has to do with the existence of costs of bankruptcy, while the second reason is based on the risk of bankruptcy, which can affect both the cash flow (CF) as the rate of interest which affects the WACC.

Including the above mentioned points, let’s start by reviewing the first model. We should first note that all the models that will be presented point, rather than to determining the exact amount of loans that the company must take, to guiding the decision-making about its capital structure.

The static exchange model (MIE) is simple to understand: the decision to take debt stems from a careful analysis of the pros and cons of assuming obligations to third parties. The reasoning part recognizing that the value of the company increases if it includes debt within the capital structure; but at the same time, it also recognises that this depends directly of the favourable effects which brings the tax savings that is derived from include the interest as a deductible expense (shields tax) and the cost of agency’s capital stock. The latter deserves a more detailed explanation. Imagine that you are the only shareholder of a company that is considering financing its expansion plans by opening the shareholding (issuing shares that will be purchased by third parties). I ask you, will you put the same intensity and interest in your work now that the FC of the business will be shared by other shareholders? Most likely the answer is no. This situation does not occur when it finances the expansion of the firm with debt, as it knows that what remains after paying its creditors can be carried entirely into its pockets. In short, then, as the capital grows with the participation of third parties, the original shareholder will increase its leisure activities (reducing, in return, the work it devotes to the company) and if this is key to the success of the business operations, the value of the firm may be affected.

On the other hand, the positive results of the presence of the two factors mentioned above are offset by the effects of the appearance of bankruptcy costs, which are amplified as the levels of leverage increase (if you want to review in depth the above, I invite you to read the previous delivery), which by affecting the FC of the firm decreases its value.

According to M&M, the difference between the value of a deleveraged (debt-free) enterprise and a leveraged (debt-free) enterprise is simply the VP of the fiscal Shields. However, if we include the impact of bankruptcy costs (represented by the VP of such costs) we will see that the real value of the leveraged firm begins to decrease from a certain leverage threshold. What then will be the optimal level of debt (d*). Simple, the point where the VP of the fiscal escudos is equal to the VP of the bankruptcy costs or seen otherwise, the point where the balance is found balance.

That point, in turn, will represent the minimum level of the signature WACC. Mathematically a lower WACC, which is the discount rate used to get the company’s value, will make it the highest possible. The chart below will help you understand it better.:

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