Chapter 14

Question 1

MM theorem

Answer 1

If CS decision has no effect on the total CFs that a firm distributes to DH and EH then the CS decision will have no effect on the total value of firms D and E. hence no effect on total FV

• in the absence of transaction costs

Question 2

MMT assumes

Answer 2

1.Total CFs to EH and DH are unaffected by how firm is financed
2. No transaction costs
3. No arbitrage opportunities exist

Question 3

Importance of transaction costs

Answer 3

• no TC means firms aren’t offering returns that the public couldn’t get elsewhere, and because other security track CFs and copy them. So investors aren’t better off from a new issuance
• the presence of TC limits the availability of return patterns that can be found in the market.

Question 4

Why assume the absence of arbitrage

Answer 4

Equilibrium prices can’t provide opportunities for riskless arbitrage profits

Question 5

How risky debt affects MMT

Answer 5

• risky debt means bankruptcy but no bankruptcy costs (so ownership and control of assets goes costlessly from EH to DH)
• if leverage increases and is not subordinated to old debt, then all DH spread assets equally making old DH worse off and EH get residual (just means EH move up in line)
• also EH increase by value DH is worse off by because FV is unaffected by CS
• for EH to remain indifferent debt must be subordinated (junior)
• junior debt offers greater yield the senior to compensate greater default risk.

Question 6

How corporate taxes affect CS choice

Answer 6

• corporate tax favors debt financing because interest is tax deductible but dividend income isn’t
• value of a levered firm increases by TcD which is the tax gain to leveraging with corporate tax only (i.e. in the absence of personal tax and bankruptcy costs)
• the value-maximizing CS includes enough debt to eliminate a firms tax liabilities-> benefits EH and DH

Question 7

How personal taxes affect CS

Answer 7

Because tax paying investors don’t benefit from the interest payment tax shield:
∴ Taxable shareholders prefer firms with little leverage

Question 8

Tax exempt shareholders

Answer 8

• tax exempt shareholder is indifferent as long as form of payment doesn’t affect amount paid
• total CFs to DH and EH are larger when paid out as debt interest payments ∴ tax exempt shareholders want firms with high leverage
• TC for share repurchases > TC for debt

Question 9

Personal taxes affect equity and debt RoR

Answer 9

Pretax rD > rE to compensate taxable investors for debts relative tax disadvantage to them.

For indifferent investors: rD(1-Td) = rE(1-Te)

Question 10

Vl = Vu + TgD

Answer 10

If investors all have personal tax rates on debt and equity income of Td and Te respectively and if corporate tax is Tc then the value of a levered firm exceeds the value of an otherwise equivalent unlevered firm by TgD.

Question 11

Miller equilibrium

Answer 11

Implies that firms should be indifferent about leverage when both corporate and personal taxes are taken into account

Question 12

How personal taxes affect dividend policy

Answer 12

**personal tax paying **
- prefer capital gains income
- can be deferred
- capital gains tax is lower than dividend tax

Question 13

Tax gain (Tg) =

Answer 13

1-[(1-Tc)(1-Te)/(1-Td)]

cDownE to remember where which tax goes where in the formula

• Tg> 0 use debt enough to cover tax liability
• Tg < 0 don’t use debt
• Tg = 0 indifferent about debt level

Question 14

Payoff to investor

Answer 14

%of equity owned[X - (1+rd)D]
- then simplify
- X is the firms cash flows or pretax earnings
- rd is the risk free interest paid to DH

Question 15

After-tax equality if debt and equity

Answer 15

Rd(1-Td) = Re(1-Te)
- investors will be indifferent between holding debt and equity