Hamada Derivation & MM

Question 1

MM 1

Answer 1

in the absence of taxes, the value of the firm remains constant regardless of how the firm is financed. (WACC stays constant)

Question 2

MM 2

Answer 2

in the presence of taxes, capital structure matters. firms with Debt have higher value because WACC decreases as the firms leverage ratio, D/E, increases. Firm value increases due to the tax shield, up to the point where the marginal gain in the tax shield is offset by the marginal cost of bankruptcy.

And also because Ke has reduced, their risk has reduced)

Question 3

UA = D+E - Tx

Answer 3

And Tx is the tax shield = TcD

Ba = UA/A Bua + Tx/A Btx
Btx = 0 under the Hamada (tax shield is perpetual and risk free)

Question 4

Hamada No Tax result to derive to

Answer 4

1. Be = Ba(1 + D/E)
   And
   Ba = Be/(1+D/E)
2. Risky debt
   Ba (1+D/E) - D/E(Bd) = Be

Question 5

Hamada tax result

Answer 5

Be = [ 1+ D/E (1-Tc)] Bua

Bua = Be/[1+D/E (1 - Tc)]

Question 6

The also section (taxes)

Answer 6

Ka = Kua (D + E - TcD/A)
D+E-TcD/A = D+E/A - TcD/A
= 1 - TcD/A
Ka = Kua ( 1-TcD/A)

The short method for WACC -> only used when Kd = Rf

Question 7

Risk transfer

Answer 7

Initially Hamada model has no debt so Bd = 0
But Taking on debt (increase in D/E) → increases the slope by = (1+D/E) → equity holders take on more risk, and expect more return.
but as more debt is taken debt decomes risky
Bd > 0, risk profile increases → Be decreases
And equity holders don’t bear the risk anymore, debt holders do.