How muh should a corporation borrow?

Question 1

What is the capital structure choice?

Answer 1

How much debt should a company take

Question 2

What is the financial leverage?

Answer 2

The higher the debt ratio, the higher the variability of shareholder returns and, on most occasions, the higher the expected return on equity

Question 3

What is the interest tax shield?

Answer 3

the reduction in taxes paid due to the tax deductibility of interest

Question 4

Why do interest expenses reduce corporate taxes?

Answer 4

because interests are not taxable

Question 5

True or false: the tax deductibility of interest increases the total income that can be paid out to all investors, including stockholders.

Answer 5

True

Question 6

True or false: in the presence of taxes, there is a benefit from issuing debt.

Answer 6

True

Question 7

What are the 2 conditions to use the WACC in a consistent way to discount Free cash Flows?

Answer 7

1. taxations is the only deviation from a M&M world
2. the firm/project continuously rebalances its leverage (D/V) to a target ratio

Question 7

How does the APV capture the effects of financing?

Answer 7

By incorporating financing effects through incremental present value calculations

Question 8

True or false: the APV doesn’t provide more flexibility in calculating the effects of debt for varying debt levels.

Answer 8

False

Question 9

Under what assumption should the APV and the WACC give the same result?

Answer 9

Constant debt-to-value ratio

Question 10

Is keeping D/V constant the same as keeping the amount of debt constant?

Answer 10

No

Question 11

True or false: the interest tax shields are as risky as the cash flows are.

Answer 11

True

Question 12

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?

Answer 12

• 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).

Question 13

What are the costs of financial distress?

Answer 13

incremental costs arising from bankruptcy or incremental value losses from distorted business decisions before bankruptcy

Question 14

What is the trade-off theory?

Answer 14

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

Question 15

What are the direct costs of financial distress?

Answer 15

legal and administrative costs of bankruptcy such as lawyers and accountants

Question 16

What are the indirect costs of financial distress?

Answer 16

• 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

Question 17

True or false: just the threat of bankruptcy can generate indirect costs.

Answer 17

True

Question 18

Why pays the bankruptcy costs?

Answer 18

Shareholders.

Question 19

Why don’t bondholders pay the bankruptcy costs?

Answer 19

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.

Question 20

True or false: direct bankruptcy costs are relatively high.

Answer 20

False

Question 21

In addition to taxes paid on corporate profits, what do investors have to pay?

Answer 21

Personal taxes on equity income and interest income

Question 22

What are the sources of equity income?

Answer 22

dividends received from the firm and capital gains from the sale of shares

Question 23

True or false: the tax rate for interest income is usually different from the tax on equity income.

Answer 23

True

Question 24

If RAD > 1, is debt taxed overall less or more than equity?

Answer 24

less

Question 25

If RAD < 1, is debt taxed overall less or more than equity?

Answer 25

more

Question 26

Over time, Rad is higher than what?

Answer 26

1, but debt income is consistently taxed more heavily tha equity income.