Chapter 16 Flashcards
What is the interest tax shield?
The reduction in taxes due to the deductibility of interest payments
What happens to the cost of equity as the firm increases leverage?
It increases due to higher financial risk.
When does a capital structure change benefit shareholders?
Only if the total value of the firm increases.
What is the formula for M&M Proposition I with taxes?
What does M&M Proposition II (no taxes) state?
Leverage increases the return and risk to equity holders.
What is homemade leverage?
When investors replicate the effects of corporate leverage on their own.
Why is financial leverage called a double-edged sword?
It magnifies both gains and losses.
What is the cost of equity in a leveraged firm (with taxes)?
What is the risk to shareholders when a firm increases leverage?
Higher earnings volatility and potential for financial distress.
What is the primary benefit of using debt financing?
The interest tax shield.
What does M&M assume about investor behavior in their propositions?
Investors can borrow and lend at the same rate as firms and are rational.
How does leverage affect EPS and ROE during economic expansion?
It increases both EPS and ROE.
What assumptions underlie M&M Proposition I (no taxes)?
No taxes, no bankruptcy costs, and perfect capital markets.
What is ROE sensitive to in a leveraged firm?
Changes in EBIT and the amount of interest expense.
What is financial distress?
A situation where a firm has difficulty meeting its debt obligations, possibly leading to bankruptcy.
What key factor allows debt to add value in a taxed environment?
Interest payments are tax-deductible.
What happens to taxes in a leveraged firm vs. an all-equity firm?
The leveraged firm pays less in taxes, increasing total cash flow to investors.
What is the break-even EBIT in capital structure decisions?
The level of EBIT at which two financing alternatives yield the same EPS.
What is capital structure?
The mix of debt and equity a firm uses to finance its operations.
What is the trade-off theory of capital structure?
Firms balance the tax benefits of debt against the costs of potential financial distress.
How does the interest tax shield affect leveraged firms?
It reduces taxes paid and increases cash flow to investors.
How does leverage affect firm cash flows to investors under M&M with taxes?
It increases after-tax cash flows due to reduced tax payments.
What is the economic interpretation of cutting the pie differently but making it bigger?
Leveraging the firm reduces taxes, increasing total value for shareholders and bondholders.
What is the fundamental reason leverage can make the “pie” bigger?
It reduces the government’s slice through lower taxes.
What is the formula for M&M Proposition II (no taxes)?
What does M&M Proposition I with corporate taxes suggest?
Firm value increases with leverage due to the interest tax shield.
What does M&M theory suggest when there are no taxes or frictions?
Capital structure is irrelevant; value is unchanged by leverage.
What is the main insight of Modigliani & Miller (M&M) Proposition I without taxes?
Capital structure is irrelevant to firm value under ideal conditions.
What is one practical use of M&M theory in corporate finance?
Understanding the trade-off between tax benefits of debt and potential financial distress costs.
What does rB represent in M&M formulas?
The interest rate or cost of debt.
What is the return on unlevered equity typically referred to as?
r0, or the cost of capital for an all-equity firm.
What is the main message of M&M Propositions I and II with taxes?
Debt adds value to the firm through the interest tax shield, but increases equity risk.
Why can leverage increase firm value with taxes?
Because interest is tax-deductible, lowering the firm’s taxable income.
What is financial leverage?
The use of debt to amplify potential returns to shareholders.
What real-world conditions challenge M&M’s assumptions?
Taxes, bankruptcy costs, agency costs, and asymmetric information.
Why might increasing debt not always increase firm value?
Because of potential bankruptcy costs, agency costs, and loss of financial flexibility.
What are the two main effects of leverage according to M&M with taxes?
Increased shareholder returns and reduced tax payments.
In M&M theory with taxes, what causes the increase in firm value?
The present value of the interest tax shield.
In M&M with taxes, what does TC * RB * B represent?
The annual tax shield from debt.
How does leverage affect EPS and ROE during a recession?
It decreases both EPS and ROE, increasing risk.
