How muh should a corporation borrow? Flashcards
What is the capital structure choice?
How much debt should a company take
What is the financial leverage?
The higher the debt ratio, the higher the variability of shareholder returns and, on most occasions, the higher the expected return on equity
What is the interest tax shield?
the reduction in taxes paid due to the tax deductibility of interest
Why do interest expenses reduce corporate taxes?
because interests are not taxable
True or false: the tax deductibility of interest increases the total income that can be paid out to all investors, including stockholders.
True
True or false: in the presence of taxes, there is a benefit from issuing debt.
True
What are the 2 conditions to use the WACC in a consistent way to discount Free cash Flows?
- taxations is the only deviation from a M&M world
- the firm/project continuously rebalances its leverage (D/V) to a target ratio
How does the APV capture the effects of financing?
By incorporating financing effects through incremental present value calculations
True or false: the APV doesn’t provide more flexibility in calculating the effects of debt for varying debt levels.
False
Under what assumption should the APV and the WACC give the same result?
Constant debt-to-value ratio
Is keeping D/V constant the same as keeping the amount of debt constant?
No
True or false: the interest tax shields are as risky as the cash flows are.
True
If debt came only with benefits, we would expect firms to borrow more than they actually do. So why is it that they don’t borrow more?
- Not all firms face high marginal tax rates.
- A firm’s ability to carry debt changes over time as profits and firm value fluctuate.
- You can only use interest tax shields if there will be future profits to shield (limited ability to carry tax forward).
- Interest income is exempt from taxation at the corporate level, but is taxed more heavily at the personal level (the effective tax benefit is lower than the corporate tax rate).
What are the costs of financial distress?
incremental costs arising from bankruptcy or incremental value losses from distorted business decisions before bankruptcy
What is the trade-off theory?
The trade-off theory states that capital structure is based on a trade-off between the benefits of tax savings and the costs of financial distress
What are the direct costs of financial distress?
legal and administrative costs of bankruptcy such as lawyers and accountants
What are the indirect costs of financial distress?
- Poor investment/operating decisions (due to possible delays in liquidation or while bankruptcy is being resolved).
- The business becomes less profitable (fiercer competition, tighter trade credit).
- Asset specificity and illiquid assets (fire sales).
- Conflict of interest between stakeholders of the firm
True or false: just the threat of bankruptcy can generate indirect costs.
True
Why pays the bankruptcy costs?
Shareholders.
Why don’t bondholders pay the bankruptcy costs?
Because they would be receiving a lower return than in the case of no bankruptcy costs. Bondholders must be paid a fair return in order to buy the bonds issued by the firm.
True or false: direct bankruptcy costs are relatively high.
False
In addition to taxes paid on corporate profits, what do investors have to pay?
Personal taxes on equity income and interest income
What are the sources of equity income?
dividends received from the firm and capital gains from the sale of shares
True or false: the tax rate for interest income is usually different from the tax on equity income.
True
If RAD > 1, is debt taxed overall less or more than equity?
less
If RAD < 1, is debt taxed overall less or more than equity?
more
Over time, Rad is higher than what?
1, but debt income is consistently taxed more heavily tha equity income.
