L3: Taxes and Financial Distress

Question 1

What is missing from the MM view?

Answer 1

Question 2

In a semi-perfect world, where we have taxes, do companies have an incentive to increase or decrease their leverage rations?

Answer 2

Question 3

MM with taxes

Answer 3

Question 4

Example:Debt tax shield

Answer 4

Question 5

Leveraged recapitalization

Answer 5

Process of using proceeds of debt issuance to buy back some of its own shares

Question 6

CF going to capital holders with taxes

Answer 6

Question 7

Value levered firm with taxes

Answer 7

Question 8

Special Case - Perpetual debt

Answer 8

Question 9

From a pure tax saving perspective:
- What is the optimal leverage for the firm?
- What if the firm just raises debt and sits on the money, investing it in risk free securities?

Answer 9

Question 10

Why do firms not change their leverage ratio to 100%?

Answer 10

Question 11

Effects of personal taxes: Taxing of debt and equity

Answer 11

Question 12

Effects of personal taxes: Taxing of debt and equity CONCLUSION

Answer 12

Question 13

Effects of personal taxes: extreme cases

Answer 13

Question 14

Effects of taxes if securities are held by insitutions that don’t pay personal taxes (e.g., mutual funds, pension funds, endowments)

Answer 14

Question 15

Bankruptcy cost / CoFD

Answer 15

Question 16

The importance of liquidity constraints

Answer 16

All problems of financial distress costs have to do with firm’s not having enough liquidity to be able to make the optimal operating decisions and still service the debt

Question 17

Debt overhang/under-investment problem

Answer 17

The problem arises because there is soo much debt hanging over this company - the company faces financial distress at the moment - and the E/H are not willing to invest in the company even though it has a positive NPV project because all the benefit will go to the debt holders and not the equity holders
→ End result:positive NPV projects won’t be done

Question 18

Does MM allow for bankruptcy?

Answer 18

Yes.

If company has a very high leverage ratio there is a chance that the company defaults and in that case the debt holder will take over the company and the value of equity will go down to 0

But:

MM does not allow for additional costs associated with bankruptcy

Question 19

Why do firms become liquidity constrained when they have too much debt?
Can’t they just issue more equity to make positive NPV investments and then payoff debt?

Answer 19

The debt overhang problem is worse with higher leverage, the more it faces financial distress, the lower the potential NPV for the E/H is

Question 20

What about raising capital in other way than equity? Can we finance the project by issuing new debt?

Answer 20

Question 21

The problem of measuring costs of financial distress

Answer 21

Question 22

Trade-off of capital structure: Adv and disadv of debt

Answer 22

Advantage of debt:

Interest tax shields

Disadvantage of debt:

Higher likelihood of facing COFD

Question 23

Trade-off of capital structure

Answer 23