2 - How much should firms borrow

Question 1

what is an incentive for firms to use debt?

Answer 1

the interest tax shield which is equal to the tax savings resulting from deductibility of interest payments.

Question 2

how does Modigliani and Miller’s proposition 1 change when corp taxes are included?

Answer 2

Levered firm will be worth more than the unlevered firm due to tax savings

Question 3

why are investors willing to pay extra for levered firms?

Answer 3

investors can not create an equivalent tax break i.e. company is doing something an individual can’t do

Question 4

do firms often change their leverage levels?

Answer 4

research has found that firms tend to maintain constant leverage

Question 5

what can be said about the value of debt if it is fairly priced?

Answer 5

it is equal to the PV of future interest payments

Question 6

what is the formula for the effective after tax borrowing rate?

Answer 6

( 1 - Tc) Rd

Question 7

how does the WACC formula change to incorporate tax shield?

Answer 7

(E/V x R-equity + D/V x R-debt) - (D/V x R-debt x Corp Tax)

Question 8

what is an example of a firm that does not have much debt but still maximised its value?

Answer 8

Facebook

Question 9

describe the classical tax system; discuss interest,dividends and cap gains

Answer 9

effectively taxed twice

• interest and dividends taxed as ordinary income
• cap gains taxed at a lower rate, can be deferred

Question 10

describe the imputation tax system; how does this affect dividends

Answer 10

receive tax credits with dividends, reduces the double taxation of dividends
effectively makes the Tc=0 from an individuals perspective

Question 11

how can personal taxes of an investor be seen as offsetting some of the corp tax benefits of leverage?

Answer 11

the amount an investor will pay for a security depends on the cashflows the investor receives after all taxes, therefore if personal tax is high - less likely to invest

Question 12

what does the relative advantage formula tell us? what does it mean is RAF < 1? what does it mean if RAF > 1?

Answer 12

RAF allows us to evaluate the effect of personal taxes firms value

• RAF < 1 = use debt
• RAF > 1 = use equity

Question 13

what are the two personal tax rates on equity?

Answer 13

• tax on dividends

- tax on capital gains

Question 14

What happens to debt policy when dividend imputation is applied?

Answer 14

it becomes irrelevant, removes the benefit that debt had over equity.

Question 15

What does Miller 1977 discuss?

Answer 15

debt and taxes
-specifically the irrelevance of personal taxes at D/E equilibrium and that capital structure only changes with Tc and Tpd change

Question 16

Are there limits to tax benefits of leverage?

Answer 16

yes, when interest expenses are greater than EBIT

Question 17

what is the optimal level of leverage?

Answer 17

when interest (tax savings) = EBIT

Question 18

why is having an optimal level of leverage difficult for a firm?

Answer 18

there is uncertainty regarding EBIT - hard to predict

Question 19

when a firm has a higher growth rate, what does this mean for the level of debt and equity?

Answer 19

• high growth = fluctuating EBIT- to avoid excess interest payment a firm will have low debt so as to not destroy value
• high growth means higher level of equity

Question 20

What has recent research shown about the levels of debt used by firms?

Answer 20

• firms have increased use of debt shields - mirroring increase in effective tax advantage of debt.
• firms have far less leverage than interest tax shield would predict

Question 21

why do firms not maximise usage of debt shield?

Answer 21

they prefer to loose out on tax savings than to destroy value - risk bankruptcy

Question 22

what do Modigliani and Miller argue for financial distress in regards to firms preferring equity over debt?

Answer 22

• equity preferred: if they don’t have enough cash they can subsequently take out a loan to cover costs or go to the market if it is efficient and raise more funds through issuing equity
• If debt is used to finance project and it is a poor investment equity holders will loose the amount, firm will experience financial distress and debt holders receive legal ownership of assets.

Question 23

how does financial distress support Modigliani and Miller’s proposition 1?

Answer 23

• financial distress caused by product failing, loose same amount if funded by 100% equity or if leverage is used: therefore capital structure does not affect the value of a firm

Question 24

What are direct costs of financial distress (2) and who bares them?

Answer 24

• increased probability of default
• increase PV of bankruptcy costs

only debt holders bare them, and will therefore seek higher return on debt if if reduced value of equity

Question 25

why do shareholders not bare the direct costs of financial distress?

Answer 25

when the firm is in trouble they have the right to walk away and leave assets to debt holders

Question 26

by how much do bankruptcy costs decrease pre-bankruptcy MV of assets? why?

Answer 26

3-4%, because it is a time consuming and complex process which requires experts for legal and professional advice

Question 27

what determines interest rate charged for debt? 3

Answer 27

• probability of distress
• direct costs (admin, operation, loss of consumer confidence)
• indirect costs (neg position in financial markets, weak against competition, conflicts between stakeholders)

Question 28

which two things must be considered when estimating indirect costs?

Answer 28

• loss to total firm value

- incremental losses associated with financial distress

Question 29

how can equity and debt be compared to calls and puts?

Answer 29

Equity holders hold long positions

• long put- ability to walk away
• long call- pay off debt and receive positive value of assets

Debt holders hold short positions

• short put - receive the amount they have lent
• short call- lenders don’t get to participate in firm profits

Question 30

why do share holders like risk and want price to change? how do debt holders differ?

Answer 30

because they hold long positions, and can gain greater returns.
debt holders want things to remain constant, low level of risk, they hold short positions

Question 31

what is the agency cost of leverage when a company is likely to go bankrupt?

Answer 31

shareholders want management to invest in negative NPV projects (take on more risk) because there is still a chance they could be profitable, equity value increases although firm value decreases through asset substitution. if not profitable it doesn’t impact shareholders only the amount of assets that debt holders receive.

Question 32

would equity holders be willing to finance positive NPV projects with new equity if firm close to bankruptcy?

Answer 32

no equity holders would be unwilling to provide their assets, because although firm value increase, it lacks the potential to pay off shareholders.

debt holders realise that is the project is likely to fail and that they will not receive their assets back so they pay less for debt, leaving less money for the firms to pay dividends/make investments so shareholders loose

Question 33

what is a debt covenant?

Answer 33

debt holders placing restrictions on the firm to ensure repayment of debt.

• limit dividends
• limit additional borrowings
• give lenders access to books/records

Question 34

what is Modigliani and Miller’s STATIC TRADE-OFF THEORY?

Answer 34

firm picks capital structure based on trade off between benefits of tax shield from debt and costs of financial distress and agency costs

Vl = Vu + PV(tax shield) - PV (financial distress) - PV (agency cost)

Question 35

according to Modigliani and Miller’s STATIC TRADE-OFF THEORY when should a firm borrow more? (2)

Answer 35

• when it has a higher marginal tax rate, i.e. the tax shield is of greater value
• when firm has more tangible assets i.e. lower asset risk = lower probability of financial distress

Question 36

If debt is needed by a firm, how can firms optimise their debt structure according to Modigliani and Miller’s STATIC TRADE-OFF THEORY? (3)

Answer 36

• bank rather than bondholders
• fewer banks
• fewer classes of debt

Question 37

up to what point should an entity use debt according to Modigliani and Miller’s STATIC TRADE-OFF THEORY?

Answer 37

up to the point where marginal benefits = Marginal costs

Question 38

what factor in the real world does Modigliani and Miller’s STATIC TRADE-OFF THEORY help to explain? how does it fail to explain real world observations?

Answer 38

-level of debt difference in different industries

• successful companies have little debt (facebook)
• imputation tax system countries (tax shield has no benefit), have similar level of debt to classical tax countries (US)

Question 39

if a firm finances a project with debt instead of finance and the price per share / earnings per share ratio is larger than if it were financed with equity, how can this be explained?

Answer 39

P/E debt > P/E equity

If issue debt, earnings takes an immediate hit because of interest payments. However growth per share is higher going forward because there are fewer shares to which to distribute future profit increases.