Capital structure (2)

Question 1

If we have personal taxes as well as corporate taxes when is corporate borrowing better?

Answer 1

When, (1-Tp)>(1-Tpe)(1-Tc)

Question 2

What is the relative tax advantage formula?

Answer 2

Relative Tax Advantage = (1-Tp)/(1-Tpe)(1-Tc)

Question 3

What does it mean if relative tax advantage <1,=1 and >1

Answer 3

If relative tax advantage:
- <1: Equity is advantageous
- >1 debt is advantageous
- =1 neither is advantageous

Question 4

What happens to the tax advantage when personal taxes are introduced?

Answer 4

• tax advantage is reduced

Question 5

When does financial distress occur?

Answer 5

• when promised to creditor are broken or honoured with difficulty

Question 6

What affects financial distress?

Answer 6

• affected by the probability of financial distress and the magnitudes of the costs

Question 7

When does bankruptcy occur?

Answer 7

• when stockholders exercise their right to default
• shareholders automatically get limited liability

Question 8

What are bankruptcy costs?

Answer 8

• costs of using a legal mechanism allowing creditors to take over when a firm defaults

Question 9

Describe the direct costs of bankruptcy?

Answer 9

• legal and administrative costs/ included accounting and other professional fees

Question 10

What are the indirect costs of bankruptcy?

Answer 10

Cost of managing a bankrupt firm, includes:
- time and effort
- impatient creditors
- bankruptcy court

Question 11

What are the costs of financial distress without bankruptcy?

Answer 11

• loss of customers and suppliers who are less willing to engage in business with firm
• loss of employees as they look for more stable employment
• fire sales of asset - loss of income as selling assets at discounted prices

Question 12

What is the trade-off theory of capital structure?

Answer 12

Total value of levered firm equals the value of a firm without leverage plus the present value of the tax savings from debt less the present value of financial distress costs

V(L)=V(U)+PV(interest tax shield)-PV(financial distress)

Question 13

What does the possibility of financial distress help explain?

Answer 13

• why firms do not hold as much debt as possible as MM with corporate taxes suggests

Question 14

Why do target debt ratios vary across firms?

Answer 14

• firms have different levels of taxable income (I.e debt)
• firms have different types of assets

Question 15

Describe the impact of higher taxable income on the debt ratio

Answer 15

• higher taxable income
• higher tax shield
• higher debt ratio

Question 16

Describe the impact of the safety of tangible assets on financial distress

Answer 16

• safer tangible assets
• lower costs of financial distress
• higher debt ratio

Question 17

How does the trade-off theory help resolve why firms choose debt levels that are too low to fully exploit the interest tax shield

Answer 17

• presence of financial distress

Question 18

How does trade-off theory explain the differences in the use of leverage across industries

Answer 18

• different industries have different probabilities and magnitudes of success as well as different investment needs

Question 19

What can trade-off theory not explain?

Answer 19

• why the most profitable companies borrow the least
• this theory predicts the most profitable companies should have higher debt ratios

Question 20

What so the signalling theory of debt?

Answer 20

• managers use leverage to convince investors that form will grow even if they cannot provide verifiable details
• debt sends a good signal
• firms with more debt are perceived as successful l/having good prospects
• value of firm rises with leverage

Question 21

What is the pecking order theory?

Answer 21

• managers have a preference to find investment using retained earnings, followed by debt and will only choose equity as a last resort
• due to costs

Question 22

How does the pecking order explain why the most profitable firms generally borrow less?

Answer 22

• more profitable firms have higher retained earnings, means firms generally don’t need to borrow as they have bought refined earnings to find investment

Question 23

Describe the effect of size in the debt ratio

Answer 23

• large firms tend to have higher debt ratios
• less probability of financial distress

Question 24

Describe the effect of tangible assets on debt ratio

Answer 24

• firms with high ratios of fixed assets to total assets have higher ratios
• less exposed to financial distress

Question 25

Describe profitability on debt ratios

Answer 25

• more profitable firms have lower debt ratios (explains by peking order theory but not trade-off)

Question 26

Describe market-to-book value on firms debt ratio

Answer 26

• firms with higher M/B have lower debt ratios are they more exposed to financial distress

Question 27

Describe the equity holder-debt holder conflict (Agency cost of debt)

Answer 27

• more present when debt is high and financial distress likely
• managers may take actions that benefit shareholders but harm creditors and lower total value of the firm
• higher debt means higher agency costs of debt

Question 28

Describe risk shifting

Answer 28

• if company is already in financial distress financial manager may undertake risky projects which tend to have lower probability of success but greater returns in an effort to save firm
• may benefit shareholders
• does not benefit creditor who doesn’t get paid

Question 29

Describe refusing to contribute to equity capital

Answer 29

• if company is in financial distress shareholders may be unwilling to contribute equity capital
• because layoffs will likely go to debt holders as they have firms claim and shareholders will see little if any payoff

Question 30

Describe cash in and run

Answer 30

• stocks holders reluctant to money into firm in financial distress but happy to take money out (dividends)
• market value of firm goes down by less than dividend paid because decline in firm value is shared with creditors
• refusing to contribute equity capital in reverse

Question 31

Describe playing for time

Answer 31

• when firm is in financial distress creditors would like to salvage what they can by the firm to settle up
• stockholders want to delay this
• various ways to do this I.e accounting changes designed to conceal true extent of trouble

Question 32

Describe bait and switch

Answer 32

• quick way to get into distress
• start by issuing limited amount of relatively safe debt
• suddenly switch and issue a lot more
• makes all debt risky
• imposing capital loss to bond holders
• capital loss is stockholders gain

Question 33

Describe the manager-shareholder conflict (Agency cost of equity)

Answer 33

• debt provided incentives for manager to run firm efficiently
• if they don’t they may end up jobless
• higher debt means lower agency costs of equity

Question 34

What is the Agency Cost Theory?

Answer 34

Agency costs of debt: increased with higher proportion of debt (lower proportion of equity)

Agency Cost of Equity: increases with higher proportion of equity (lower debt)