Week 5 - How much should a firm borrow? (Capital structure II)

Question 1

Are interest payments deducted from pre-tax or post-tax income?

How do interest tax benefits arise?

Answer 1

Pre-tax income!

Tax benefits come from ASYMMETRIC TAX TREATMENT between firms w/ and w/o leverage, not taxes.

Question 2

Interest tax shield

Answer 2

(D x rD) x tC

Question 3

In efficient markets, who benefits from the interest tax shield?

Answer 3

Equity holders.
- Leverage increases firm value by the size of the interest tax shield.
- There is a larger size of the pie left for equity holders, and smaller size of the pie for the government. // total FCFs are higher by the amt of the interest tax shield

Another way to interpret the ITS is that it effectively represents a GOVERNMENT SUBSIDY of the cost of debt, so the EFFECTIVE COST of debt is reduced

Question 4

After-tax WACC
ie. the EFFECTIVE after-tax cost of capital

Answer 4

= rD(1-tC)(D/V) + rE(E/V)

= WACC(before tax) - rDtC*(D/V)

Even in a world of taxes, a company’s cost of capital is still the true cost of capital!

Question 5

2 implicit assumptions when discounting a project’s cash flows using the firm’s WACC

Answer 5

1. Project must have the same RISK as the overall assets of the firm
   - Must always discount cash flows at a discount rate that reflects the risk of the CFs.
2. Project must have same FINANCING as the firm

Question 6

MM Proposition II & target leverage ratio

Answer 6

MM Proposition II still holds as long as firm maintains SAME target leverage ratio. EVEN WHEN INTRODUCE TAXES
^Co’s cost of capital still = unlevered cost of capital

Question 7

2 conditions for discounting FCF using the (after-tax) WACC

What is the alternative if either assumption is violated?

Answer 7

1. If taxes are the ONLY deviation from MM
   AND
2. the firm continuously rebalances its leverage to a target ratio D/V

A more flexible is the Adjusted Present Value (APV)
APV = base case NPV {ie. assuming project is all-equity financed} + sum of PV of FINANCING SIDE EFFECTS

eg. interest tax shield (+), issue costs of securities (-), subsidies by a supplier/govt (+), bankruptcy cost, agency cost

Question 8

2 ways to get cash flows of a levered firm + MM Proposition I with taxes

Answer 8

1. Buy shares of levered firm
2. Buy shares of an unlevered firm + buy a security that pays the amount of INTEREST TAX SHIELD

By no-arbitrage, VL = VU + PV(ITS)

Question 9

PV(ITS) if debt is fixed

Answer 9

= (D x rD x tC) / rD
= D x tC

If assume constant tax rate, risk of interest tax shield of permanent debt = risk of debt itself. Hence, rD is the appropriate discount rate.

This eqn holds even if the debt is NOT risk-free, as long as markets are efficient / fairly priced.
b/c rD already reflects the risk of DEFAULT

Question 10

In a world of tax-deductible interest, what does having debt do to a firm?

Answer 10

In a world of tax-deductible interest, having debt INCREASES VALUE of firm.

Question 11

Financial distress

Answer 11

A firm is in financial distress when it is experiencing difficulty meeting its debt obligations (i.e. interest and/or principal).

Firm is in default/bankrupt/insolvent when the firm fails to make debt payments.

Bankruptcy/Insolvency is the legal process by which control of a bankrupt firm’s assets is handed over to its creditors/debt holders.

Question 12

2 conclusions about bankruptcy costs.
1. Bankruptcy costs are paid by SHAREHOLDERS (UPFRONT)
2. Direct bankruptcy costs are relatively small (reduction in firm value < bankruptcy cost) - 2 reasons
Elaborate.

Answer 12

1. With bankruptcy costs, debt holders know they will get less if the firm defaults.
   - So they demand MORE (larger face value) in the event that the firm does not default (otherwise, no lending)
   - This leaves less money for shareholders
   -> Value of equity decreases, value of firm decreases

2i) Bankruptcy is NOT CERTAIN, so overstated the risk of bankruptcy
ii) Bankruptcy costs occur in the FUTURE, so worth less in present value basis.

Question 13

From PS5,
Why did the share price drop when the co. announces it will issue debt? (ref. to bankruptcy costs)

Answer 13

1. Since share price should drop on the announcement of the debt issue, ALL shareholders experience a loss of $1.01 per share
2. With 10m shares outstanding, the total loss to shareholders is 1.01 x 10m = … exactly = PV(BANKRUPTCY COSTS)
   ie. shareholders pay for the expected COSTS OF FINANCIAL DISTRESS upfront although the cost is borne by debt holders in the event of bankruptcy