Lecture 8: Optimal Financing Policy

Question 1

What is the objectives of firms in relation to personal taxes?

Answer 1

When personal taxes are introduced- the objective of the firm is to arrange the cap structure to minimise the present values of ALL TAX (including corporate, personal tax paid by debt holders and personal tax paid by equity holders

Question 2

What are the tax effects if $1 of income is paid out to a bondholder (paid out as interest)

Answer 2

$nil taxation at corporate level (given a deduction) - therefore only tax will be to the bondholder on personal income
Tax= 1-Tp (personal tax by debtholders)

Question 3

What ? are the tax effects if $1 of income is paid out as equity

Answer 3

Will be taxed at the corporate level & personal level

Tax= (1-TPe)*(1-Tc) (personal tax paid by equity holders and corporate tax)

Question 4

What does the relative advantage formula show?

What does it mean if the formula is more than 1, less than 1 or equity to 1

Answer 4

Top part of formula: after tax income that is paid to bondholders (paid out as interest)
Bottom part of formula: after tax income paid to stockholders (paid out as equity distribution)
If more than 1: Debt is better
If less than 1: Equity is better
If equal to 1: debt policy

Question 5

What is the relative advantage formula if personal tax by debtholders is the same as the personal tax paid by equity holders?

Answer 5

(1)/ (1-Tc)

Question 6

What is the relative advantage formula and the net tax advatnage of debt formula formula?
How do we calculate TPE (in relation to operating income)

Answer 6

RAF= (1-rd)/ (1-tc)(1-Tpe)
Net tax advantage: As above - except negatieve sign instead of divide sign
TpE= (Dividend Rate * Portion of earnings paid out)(Capital gains rate* Portion of earnings not paid out)

Question 7

When will tax shields not be available?

Answer 7

If a firm cannot earn enough income to cover interest repayment

Question 8

What is financial distress? When is financial distress clearly present?

Answer 8

Financial distress: Is when promises to creditors are broken or honoured with difficulty.

• Leads to a lower market value of the firms debt and equity securities
• Clear case: when the FV of debt exceeds the total MV of debt and equity

Question 9

What is the market value of the firm - accounting for financial distress as well?

Answer 9

MV of firm= value if all-equity financed + PV (tax shield) - PV (costs of financial distress)

Question 10

Where is the optimal debt ratio?

Answer 10

Where the firms overall value is maximised: that is- where the marginal benefit of tax shield due to additional borrowings is just offset by the marginal increase in the PV costs of financial sitress

Question 11

What are the costs of financial distress in relation to both banktruptcy and other factors

Answer 11

1) Bankruptcy costs (direct &indirect- costs of using legal services to allow creditors to take over)
2) Costs of financial distress short of bankruptcy
- Customers, suppliers and employees may not want to stay with the firm
- Conflict of interest between debtholders and shareholders may lead to distorted investment decisions
- Shareholders acting in their own interest can play ‘games’ in their favour - at the expense of creditors that reduce the value of the firm

Question 12

What are the two types of game?

Answer 12

1) Risk shifting by taking negative NPV projects

2) Refusing to contribute equity capital

Question 13

What does risk shifting by undertaking negative NPV projects involve (using cash?)

Answer 13

Negative NPV projects will be beneficial shareholders, as it will reduce the value of the firm as a whole (cash reserve), and therefore the value of the debt will fall:

• Betting with the debtors holders money: shareholders get the most if the project pays off
• Tempting when the odds of default are high
• If the reduction in the value of the debt is greater than the firm value - shareholders will be better off

Question 14

What does refusing to contribute equity capital involve?

Answer 14

If equity projects will increase the value of the firm, then the value of the debt will increase. Shareholders stand to loose what debt holders gain as equity value goes up

• Any increase in firm value must be shareholder by both debtor holders and equity holders (value of firm increases, so does value of debt)
• The greater the default possibility, the more debt holders have the chance to gain from investments that increase value

Question 15

What are the agency costs of debt?

Answer 15

The temptation for the manager to play games that are in the favour of shareholders

Question 16

What does the trade off theory state?

What type of debt ratio would a safe, profitable company have? What about a risky, intangible asset company?

Answer 16

Firms have a target debt ratio: that balances the tax shields and costs of financial distress (that maximise value)

• Companies with tangible, safe assets and plenty of taxable income= should have higher debt ratios
• Companies with intangible, unsafe assets with low income= should have lower debt ratios

Question 17

What is the flaw with the trade off theory?

Answer 17

The theory suggests that companies that have high profits should mean more debt servicing.. but this is usually actually not the case

Question 18

What does the pecking order theory state?

Answer 18

• The pecking order theory states that firms will try to use internally generated cash first to finance investments.
• If more cash required: first issue debt, then hybrid securities and then new equity as a last resort

Question 19

Why does the pecking order theory exist. What are the responses of optimistic and pessemestic managers?

Answer 19

Pecking order theory arises due to: INFORMATION ASYMMETRY (managers know more than outsiders).
- Issue debt first rather than underpriced equity
Optimistic managers: would rather issues debt than underpriced shares and doing shareholders a favour
Pessemestic managers: would love to issue overpriced equity - but investors understand this and means that the current share price is overpriced and will lead to a fall in the share price

Question 20

What did the resutlts of Rajan and Zingales study from 1995 find?

Answer 20

The debt ratios of large companies in Canada, France, Germany, Italy and Japan depend on four factors

1) Size: Positive relation (Trade off theory)
2) Tangible Assets: Positive correlation (Trade off theory)
- Profitability: Negative correlation (Pecking order theory)
4: Market to book ratio: negative correlation

Question 21

What is financial slack?

Answer 21

Financial slack is cash, marketable securities and readily saleable real assets and ready to access the debt markets or to bank financing

Question 22

Which types of firms is financial slack most valuable for?

Answer 22

Growth companies - that need financing to be quickly available for good investments

Question 23

What is the bright side of financial slack?

Answer 23

Without sufficient financial slack:

• Managers may have to give up undertaking positive NPV projects
• May have to work down the pecking order and issue debt (incurring costs of financial distress)

Question 24

What is the dark side of financial slack?

Answer 24

Holding too much cash and assets means:

• Managers may over invest, empire build or expand theory perks
• Excess cash may not be distributed to shareholders - which makes the agency relationship even worse

Question 25

What would a debt for equity exchange, vs an equity of debt exchange be good news?

Answer 25

If issuing more debt - a sign that management are confident about future earnings
If trying to get rid of debt - sign management may think may not be as proftiable in the future