L3: Taxes and Financial Distress Flashcards
What is missing from the MM view?
In a semi-perfect world, where we have taxes, do companies have an incentive to increase or decrease their leverage rations?
MM with taxes
Example:Debt tax shield
Leveraged recapitalization
Process of using proceeds of debt issuance to buy back some of its own shares
CF going to capital holders with taxes
Value levered firm with taxes
Special Case - Perpetual debt
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?
Why do firms not change their leverage ratio to 100%?
Effects of personal taxes: Taxing of debt and equity
Effects of personal taxes: Taxing of debt and equity CONCLUSION
Effects of personal taxes: extreme cases
Effects of taxes if securities are held by insitutions that don’t pay personal taxes (e.g., mutual funds, pension funds, endowments)
Bankruptcy cost / CoFD
The importance of liquidity constraints
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
Debt overhang/under-investment problem
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
Does MM allow for bankruptcy?
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
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?
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
What about raising capital in other way than equity? Can we finance the project by issuing new debt?
The problem of measuring costs of financial distress
Trade-off of capital structure: Adv and disadv of debt
Advantage of debt:
Interest tax shields
Disadvantage of debt:
Higher likelihood of facing COFD
Trade-off of capital structure
