Chapter 18 Flashcards
Define financial risk?
Risk to shareholders resulting from the use of debt
Define financial leverage?
The increase in the variability of shareholder returns that comes from the use of debt
Define interest tax shield?
Tax savings resulting from deductibility of interest payments
What is an advantage of debt financing?
The interest that the firm pays is a tax-deductible expense tf the return to bondholders escapes taxation at the corporate level
See table 18.1
Shows highest debt to debt-to-equity firms include airlines and hotels, and lowest is internet info providers
See
Table 18.2 showing tax shields, see how to work them out
What is a tax shield? What does it mean?
The interest that the company pays is a tax-deductible expense - it means the bondholder escapee taxation at the corporate level
Present value of a tax shield? (2)
PV(tax shield) = tax shield/interest rate
PV(tax shield)=(T(c)r(D)D)/r(D)
=T(c).D
T(c)=corporate tax rate
r(D)=return on debt
D=amount borrowed
Under these assumptions, the PV of the tax shield is independent of the return on debt
Interest payment =?
Interest payment=return on debt x amount borrowed
Interest payment = r(D).D
Corporate US tax rate (marginal)?
35%
Explain how tax shields can act as a valuable asset?
Suppose that the debt of L is fixed and permanent; then L can look forward to a permanent stream of cash flows ($28/yr in example)
What do the tax shield depend on?
The corporate tax rate and the ability of the firm to earn enough to cover the interest payments
What is the risk of tax shields?
Same as that of the interest payments that’s generating then (eg. 8%)
What is the tax benefit?
Tax benefit=D.r(D).T(c)
What does it mean for a security to be in perpetuity?
It has no fixed maturity date
Value of firm =? (MMP1 + taxes)
And special case of fixed, permanent debt?
Value of firm=value if all-equity-financed + PV(tax shield)
Special case:
Value of firm=value if all-equity-financed + T(c)D
See
Slides page 4 example and learn it
Explain how tax shield violate MM’s proposition 1?
MMP1 essentially says the value of the pie doesn’t depend on how it is sliced, where the pie is the firms assets and slices are debt and tequity claims.
In reality there is a third slice; the governments slice. The value of the pie still remains the same, but anything the firm can do to reduce the governments slice will make stockholders better off; and example of this is to borrow money tf reducing the tax bill tf increasing cash flows to debt and equity investors
What is the after-tax value of a firm, and how is it affected by increasing debt?
The sum of its debt and equity values as shown in a normal market value balance sheet.
It increases by the PV(tax shield)
See
Example 18 Johnson and Johnson!!! Page 463 12th edition
The edited MMP1 formula implies that all firms should be 100% debt financed since firm value and stockholders’ wealth increases as D increases. Why does this not actually hold? (3)
1) unrealistic to think of debt as fixed and perpetual
2) many firms face a marginal tax rate less than 35%
3) can’t use internet tax shield unless there will be future profits to shield, and no firm can be certain of this
But this still isn’t enough reason not to do it tf 2 possible ways out:
1) examine system of corporate and personal taxation more thoroughly may uncover a tax disadvantage of corporate borrowing
2) perhaps firms that borrow incur other costs (eg. Bankruptcy costs)
Relative advantage formula (RAF)?
RAF = (1-T(p)) / (1-T(pE))(1-T(c))
Where RAF is relative tax advantage of debt over equity
T(p) = personal tax rate on interest
T(pE) = effective personal tax rate on equity income
T(c) = corporate tax rate on interest
What if T(pE)=T(p)?
Then RAF depends only on corporate tax rate and tax advantage of corporation borrowing is exactly how MM calculated
What to do when:
a) RAF>1
b) RAF<1?
a) use debt
b) use equity
