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Dear sir,
I want to know about CAPM Beta formula which is “B= Ba*(equity/equity + Debt*1-t)”. There is Debt which is net off tax i want to know the reason of tax effect. Why Debt is net off tax.
I’ll be thankful to you for your utmost favor.
Kindly Answer me in detail.It is actually derived from the Modigliani and Miller formula, and it is impossible to type up the full proof of Modigliani and Miller here (and is irrelevant for the exam anyway).
However, the basic reasoning is because debt interest is tax allowable, and so more debt borrowing increases the total value of the company (in theory) because the company is getting the benefit of the tax relief (the tax shield) which is not applicable to equity borrowing (because dividends are not tax allowable).
Thank you sir for your response.But I wanted to ask why debt is made net of tex in beta formula(b*equity/equity+debt*1-tex),actually tex relief is given on intrest not on debt.
Yes it is, but the market value of the debt is determined by the pre-tax interest receipts (it is the investors who determine the market value). Since the interest attracts tax relief for the company, the company is getting the benefit of the present value of those tax reliefs which is the same as tax rate times the market value.
(Assuming of course that the debt is irredeemable, but the formula (as with Modigliani and Miller) assumes irredeemable debt. We still use the formula even when the debt is not irredeemable, which is one of the limitations of any answers that result.)
thank you sir for your response. Unfortunately, i did not understand the answer .If you describe it in simple words then i easily understand the actual reason
i’ll be very thankful for your favorJust suppose that the interest is $20 per annum and the investors required return was 10%.
Assuming irredeemable debt, then the market value will be $200. (If this is not clear then you must watch the F9 lectures on valuations of securities).
As far as the company is concerned they will get tax relief of the interest – if tax is 30%, then they will save $6 per year and the net cost will be $14 per year.
The present value of their interest payments will therefore be (at 10% again) $140.This is the same as multiplying the MV ($200) by (1-t).
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