Chapter 15 - Finance Flashcards
Finance
Whats the formula of the interest tax shield?
Interest Tax Shield = Corporate Tax Rate x Interest Payments
Whats the interest tax shield?
The gain to investors form the tax deductibility of interest payments.
What is recapitalization?
When a firm makes a significant change to its capital structure
What happens at a share repurchase?
The share price goes up
–> Let’s say the company will repurchase $100 million. The share price is $15, so 100 million / 15 = 6.667 million shares. They had 20 million shares outstanding, so now they have 20-6.667 = 13.333 million shares outstanding. The total value of equity stays the same ($235 million) so the new share price is $235 million/ 13.333 million shares = $17.625. So the share price has gone up (more equity worth for less shares).
Whats the market value balance sheet?
The market value balance sheet states that the total market value of a firm’s securities must equal the total market value of the firm’s assets. In the presence of corporate taxes, we must include the interest tax shield as one of the firm’s assets.
Which of the following statements is FALSE?
A) Given a 35% corporate tax rate, for every $1 in new permanent debt that the firm issues, the value of the firm increases by $0.65.
B) The firm’s marginal tax rate may fluctuate due to changes in the tax code and changes in the firm’s income bracket.
C) Many large firms have a policy of maintaining a certain amount of debt on their balance sheets.
D) Typically, the level of future interest payments varies due to changes the firm makes in the amount of debt outstanding, changes in the interest rate on that debt, and the risk that the firm may default and fail to make an interest payment.
A) Given a 35% corporate tax rate, for every $1 in new permanent debt that the firm issues, the value of the firm increases by $0.35.
Which of the following statements is FALSE?
A) The tax deductibility of interest lowers the effective cost of debt financing for the firm.
B) When a firm uses debt financing, the cost of the interest it must pay is offset to some extent by the tax savings from the interest tax shield.
C) With tax-deductible interest, the effective after-tax borrowing rate is r(τC).
D) The WACC represents the cost of capital for the free cash flow generated by the firm’s assets.
C) With tax-deductible interest, the effective after-tax borrowing rate is r(1 - τC).
Which of the following statements is FALSE?
A) The higher the firm’s leverage, the more the firm exploits the tax advantage of debt, and the lower its WACC.
B) Corporate taxes lower the effective cost of debt financing, which translates into a reduction in the weighted average cost of capital.
C) Because the firm’s free cash flow is computed without considering the firm’s leverage, we account for the benefit of the interest tax shield by calculating the WACC using the before tax cost of debt.
D) The reduction in the WACC increases with the amount of debt financing.
C) Because the firm’s free cash flow is computed without considering the firm’s leverage, we account for the benefit of the interest tax shield by calculating the WACC using the after tax cost of debt.
Which of the following statements is FALSE?
A) Once investors know the recap will occur, the share price will rise immediately to a level that reflects the value of the interest tax shield that the firm will receive from its recapitalization.
B) When securities are fairly priced, the original shareholders of a firm capture the full benefit of the interest tax shield from an increase in leverage.
C) In the presence of corporate taxes, we do not include the interest tax shield as one of the firm’s assets on its market value balance sheet.
D) We can analyze the recapitalization using the market value balance sheet; it states that the total market value of a firm’s securities must equal the total market value of the firm’s assets.
C) In the presence of corporate taxes, we include the interest tax shield as one of the firm’s assets on its market value balance sheet.
Which of the following statements regarding recapitalizations is FALSE?
A) With a recapitalization, even though leverage reduces the total value of equity, shareholders capture the benefits of the interest tax shield up front.
B) The share price always rises after the completion of the recapitalization.
C) Leveraged recaps were especially popular in the mid- to late-1980s, when many firms found that these transactions could reduce their tax payments.
D) When a firm makes a significant change to its capital structure, the transaction is called a recapitalization.
B) This is only always true if we ignore the other potential side effects of leverage, such as the costs of financial distress.
Which of the following statements is FALSE?
A) The value of a firm is equal to the amount of money the firm can raise by issuing securities. B) By reducing a firm’s corporate tax liability, debt allows the firm to pay more of its cash flows to investors.
C) Equity investors must pay taxes on dividends but not capital gains.
D) For individuals, interest payments received from debt are taxed as income.
C) Equity investors must pay taxes on dividends and capital gains.
Which of the following statements is FALSE?
A) Personal taxes have the potential to offset some of the corporate tax benefits of leverage.
B) The actual interest tax shield depends on the reduction in the total taxes (both corporate and personal) that are paid.
C) The amount of money an investor will pay for a security ultimately depends on the benefits the investor will receive—namely, the cash flows the investor will receive before all taxes have been paid.
D) Just like corporate taxes, personal taxes reduce the cash flows to investors and diminish firm value.
C) The amount of money an investor will pay for a security ultimately depends on the benefits the investor will receive—namely, the cash flows the investor will receive after all taxes have been paid.
Which of the following statements is FALSE?
A) To determine the true tax benefit of leverage, we need to evaluate the combined effect of both corporate and personal taxes.
B) A personal tax disadvantage for debt causes the WACC to decline more slowly with leverage than it otherwise would.
C) Personal taxes have an indirect effect on the firm’s weighted average cost of capital.
D) In the United States and many other countries, capital gains from equity have historically been taxed more heavily than interest income.
D) In the United States and many other countries, capital gains from equity have historically been taxed at a lower rate than interest income.
Which of the following statements is FALSE?
A) Aside from taxes, another important difference between debt and equity financing is that debt payments must be made to avoid bankruptcy, whereas firms have no similar obligation to pay dividends or realize capital gains.
B) Increasing the level of debt increases the probability of bankruptcy.
C) A firm receives a tax benefit only if it is paying taxes in the first place.
D) To the extent that a firm has other tax shields, its taxable earnings will be increased and it will rely more heavily on the interest tax shield.
D) To the extent that a firm has other tax shields, its taxable earnings will be decreased and it will rely less heavily on the interest tax shield.
Which of the following statements is FALSE?
A) A biotech firm might be developing drugs with tremendous potential, but it has yet to receive any revenue from these drugs. Such a firm will not have taxable earnings. In that case, a tax- optimal capital structure does not include debt.
B) No corporate tax benefit arises from incurring interest payments that regularly exceed EBIT. C) The optimal level of leverage from a tax saving perspective is the level such that interest equals EBIT.
D) In general, as a firm’s interest expense approaches its expected taxable earnings, the marginal tax advantage of debt increases, limiting the amount of equity the firm should use.
D) In general, as a firm’s interest expense approaches its expected taxable earnings, the marginal tax advantage of debt decreases, limiting the amount of equity the firm should use.
