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
See
example page 8 slides and figure 18.1
F18.1 shows that firm’s capital structure should be arranged to shift operating income down branch where tax is least
F18.1 shows that firm’s capital structure should be arranged to shift operating income down branch where tax is least, what are 2 problems with this?
1) SH roster of any large firm will have both tax exempt investors, and millionaires paying highest tax rate on equity tf different T(pE)
2) Same happens with personal tax rate T(p)
How would a firm be able to tell the net advantage of debt?
They’d need to know the tax rates faced by the marginal investor (one indifferent between holding debt or equity)
What are costs of financial distress?
Costs arising from bankruptcy or distorted business decisions before bankruptcy
When does financial distress occur?
When promises to creditors are broken, normally due to failure to pay interest/principal/both
Define financial distress?
Events preceding and including bankruptcy, such as loan violation
See
equation top of cont. 1 side 1 and writing
What is the trade-off theory of capital structure?
Theory regarding the trade off between tax benefits and costs of distress
What does PV(costs of FD) depend on?
Probability of costs and magnitude of their effects if they occur
Draw diagram and learn explanation for trade-off theory?
Now (see notes) (don’t get!)
When do corporate bankruptcies occur?
When SHs exercise their right to default
Often results in former creditors becoming new SHs and old SHs left with nothing
Explain bankruptcy in an unlimited company?
The firms SHs have to cover the difference between the firm’s asset value and the BHs claim if the firm defaults
See
figures 18.3 and 18.4 page 12
What is bankruptcy?
A legal mechanism allowing creditors to take over when the decline in value of assets triggers a default tf bankruptcy is not the cause of the decline in value, it is the result
What are bankruptcy costs?
The legal fees etc. of going bankrupt, which will be paid out of the security holders’ assets (pages 469 and 470 good explanation)
What is risk shifting?
The change in attitudes of BHs and SHs when a firm is in financial distress
eg. SHs may be tempted to abandon trying to maximise firm’s MV and pursue self interest
Explain an indirect cost of bankruptcy?
Requires consent of court for managers to make routine decisions such as asset selling or reinvesting to revive firm (see pages 13 and 14 for examples and pages 472 and 473 for explanations!)
(see top of notes page 2 side 2) What does the example show?
Shows when in financial distress stockholders of levered firms gain when business risk increases tf financial managers acting in interest of SHs may take risky/-ve NPV projects.
This is because they are essentially gambling with the BHs money; if the investment fails, doesn’t really affect them since they’d be unlikely to get their money back anyway, if it works they reap the benefits!
Explain why SHs may pass up positive NPV investments when firm is in FD?
Holding business risk constant, any increase in firm value is shared between BHs and SHs tf investment from SHs has a reduced value tf they may pass up positive NPV investments
3 other games that may be played by firms in financial distress?
1) Cash in and run
2) Playing for time
3) Bait and switch
What is meant by ‘cash in and run’?
SHs may pay out dividends to themselves since the MV of the firm will fall by less than the size of dividend (essentially the decline in firm value will be shared with the creditors)
What is meant by ‘playing for time’?
When firm is in FD, creditors would like to salvage what they can by forcing the firm to settle up; SHs want to delay this tf use:
- Accounting techniques
- Cutting corners on maintenance etc to make firm’s operating costs look better etc.
What is meant by ‘bait and switch’?
Not always done by firms in FD, but can lead to FD. The firm starts conservatively by issuing a limited amount of relatively safe debt, then suddenly switch and issue more! Makes all the debt more risky, tf capital ‘loss’ on old BHs and gain to SHs
What are agency costs (of borrowing?
Costs of poor investment and operations decisions by firms playing games
