Lent Term - Lecture 2

Question 1

Why does debt have a tax advantage?

Answer 1

Interest payments are tax deductible. Dividends and retained earnings are taxed.

Question 2

If there is a repurchase of shares what should the change in value of equity be equal to in a repurchase of shares via debt issue?

Answer 2

The tax shield

Question 3

What is the average debt to equity ratio/

Answer 3

Around 35%

Question 4

Why does bankruptcy not necessarily violate M&M?

Answer 4

In theory bankruptcy is just a transfer of ownership from equity holders to debtholders so it does not violate M&M. In reality though bankruptcy is complicated and can impose costs on the firm.

Question 5

What is the optimal level of debt K*?

Answer 5

K* is where the marginal tax benefit is equal to the marginal bankruptcy cost

Question 6

What are 2 forms of bankruptcy costs?

Answer 6

Direct - admin costs, time cost, flash sales. Typically 2.5% for large firms and 20%-25% for large ones.

Indirect - Loss of customers, lack of trade credit, lake of key employees, inability to raise finance

Question 7

Why can bankruptcy be more costly for some firms than others?

Answer 7

Firms with tangible assets may find that bankruptcy is far less costly than for firms with intangible assets

Question 8

What is the trade-off theory?

Answer 8

The trade-off theory states that firms should choose their debt-equity mix to balance the tax benefits of debt with expected bankruptcy costs