Moral Hazard

Question 1

A company pays 5 million € in interest, its corporate tax rate is 40%. What is the amount of the company’s ANNUAL tax shields generated by this debt? (enter the value in millions e.g. 3 for three million)

Answer 1

5*0.4=

= 2

Question 2

A company pays a 5% interest rate or 5million Euros in interest on a total debt of 100million. The corporate tax rate is 40%. What is the PRESENT VALUE of the company’s tax shields generated by this debt if we assume that it is perpetual and constant in absolute values? (enter the value in millions e.g. 3 for three million)

Answer 2

PV = tax_rataDEBT = 0.4100 =

= 40

Question 3

A company would have an enterprise value of 400 million without debt. Assume that the present value of the tax shields generated by its debt is 40 million. What is the enterprise value of the levered company?

Answer 3

PV = 400 + 40 =

= 440

Question 4

An unlevered company with an enterprise value of €400 million and a share price of €10 decides to add €100million in permanent debt to its balance sheet and decrease equity by the same amount. If tax rates are 40% by how much should the share price increase. (in Euros)

Answer 4

vL = vU + PV(tax shield)
vL = 400 + 40 = 440
V(firm) = V(equity) - V(debt)
V(equity) = 440 - 100 = 340
30 millions share outstanding ---> Share price new = 340/30 = 11.333

Price increase = 1.3333

Question 5

When will the share price increase from €10 to €11?

• When the increase in leverage is announced?
• When the increase in debt is implemented?

Answer 5

WHEN THE INCREASE IN LEVERAGE IS ANNOUNCED

Question 6

Why will the real effect of tax shields likely be lower than the effect we calculated in the previous questions? Provide 3 examples.

Answer 6

• BANKRUPTCY COSTS
• PERSONAL TAXES
• CONSIDERING THE TAX SHIELD AS “SAFE”

Question 7

With a debt level of €100 million a company has a probability of failure of 10%. In case of failure, it will lose €50 million in value because of the direct costs of bankruptcy as well as the loss of clients. What are the expected bankruptcy costs? (in millions)

Answer 7

10% * 50 =

= 5

Question 8

What will be the enterprise value of our company with €100 million in debt, given that it had an unlevered value of €400million, tax shields of €40million, and expected bankruptcy costs of €5million?

Answer 8

vL = vU + PV(Tax-shield) - E[Bankruptcy costs]
vL = 400 + 40 - 5 =
= 435

Question 9

Suppose that with €100 million in debt, the tax shields are €40 million and expected bankruptcy costs of €5million, whereas, with €80 million, tax shields are €32million and the probability of bankruptcy is 0. Which one is the better level of debt?

• €100 million
• €80 million

Answer 9

vL = vU + PV(Tax-shield) - E[Bankruptcy costs]

vL = k + 40 - 5 =
= k +35
vL2 = k + 32 - 0 =
= 32

ANSWER: 1 —> 100 MILLION

Question 10

Which one of the following companies should have the highest expected bankruptcy costs for a given percentage of debt?

• Biotech startup
• Copper mine

Answer 10

BIOTECH STARTUP:

BANKRUPTCY IS A CHANGE OF OWNERSHIP FROM SHAREHOLDERS TO CREDITORS: A COPPER MINE CAN STILL RUN IN BANKRUPTCY, WHILE A BIOTECH STARTUP WOULD FACE MAJOR BANKRUPTCY COSTS (VALUE IN HUMAN CAPITAL, CLIENTS, REPUTATION, … )