Capital Structure II: Debt and Taxes, Financial Distress and Managerial Incentives

Question 1

Who are the actors in the capital structure?

Answer 1

Equity holders, debt holders, and managers

Question 2

What does optimal capital structure depend on?

Answer 2

Taxes and financial distress/agency costs

Question 3

When do corporations pay taxes?

Answer 3

On profits after interest payments are deducted.

Question 4

Does interest expense reduce the amount of corporate taxes?

Answer 4

Yes!

Question 5

What is an interest tax shield?

Answer 5

Interest tax shield = Corporate Tax Rate * Interest Payments

Focuses on reduction in taxes paid due to the tax deductibility of said interest.

Question 6

What is the benefit of the interest tax shield?

Answer 6

Benefit is the present value of the stream of future interest tax shield the firm will receive.

Note: Cash flows a levered firm pays to investors will be higher than they would be without the leverage by the amount of the interest tax shield.

CF = CF w/o Leverage + Interest Tax Shield

Question 7

MM Proposition I with Taxes

Answer 7

Vl = Vu + PV (Interest Tax Shield)

Question 8

Why is the level of future interest payments uncertain?

Answer 8

This is due to changes in marginal tax rate, amount of debt outstanding, interest rate on debt, and risk of the firm.

Question 9

What does no arbitrage imply if debt is fairly priced?

Answer 9

Market value must equal present value of future payments.

MV debt = D = PV(Future Interest Payments)

Should tax rate be constant then:

PV(Interest Tax Shield) = PV (t x Future Interest Payments) = t x PV(Future Interest Payments = t x D

Question 10

What is done in response to a firm adjusting its leverage to maintain a target debt-equity ratio?

Answer 10

Discount free cash flow using weighted average cost of capital.

Question 11

How are cash flows to investors taxed twice?

Answer 11

Once at corporate level then again for investors as they receive interest or dividend payment.

Individuals receive interest payments derived from debts as income.

Equity investors must pay taxes on individual dividends and capital gains.

Question 12

Does the actual interest tax shield depend on corporate and personal taxes paid?

Answer 12

Yes

Question 13

Effective Tax Advantage of Debt

Answer 13

Every dollar received after taxes by debt holders from interest payments costs equity holders 1-t on an after tax basis.

t = [(1-tc)(1-te)]/(1-ti)

When no personal taxes on debt income (ti = -) or personal tax rates on debt an equity income are the same (ti = te) then t = tc

Question 14

Do Firms Prefer Debt?

Answer 14

Yes, during raises of external funds - not all investments are external. No preferred during investments and growth by internally generated funds.

Varies by industry - growth sectors carry little but airlines and automakers may have high leverage ratios.

Question 15

What does a firm need to receive full tax benefits of leverage?

Answer 15

No use 100% debt financing and hold taxable earnings.

Question 16

Is there a corporate tax benefit to debt?

Answer 16

Not when incurring interest payments exceed EBIT.

Question 17

What is the optimal level of leverage from a tax savings perspective?

Answer 17

Interest = EBIT

Firm shields all of its taxable income thus avoiding any tax disadvantaged excess interest.

Note: Unlikely firms can predict future EBITs well.

Question 18

Are firms under or over leveraged on average?

Answer 18

Underleveraged

Question 19

Does the risk of bankruptcy pose a concern form increasing level of debt?

Answer 19

Yes! It is costly and could offset any advantages from debt financing.

Question 20

What financial distress?

Answer 20

Difficulty to meet debt obligations

Question 21

What does it mean to default?

Answer 21

Firm fails to make required interest or principal payments on debt. Debt holders are given rights to certain assets and legal ownership of firm through bankruptcy

Question 22

Does equity financing carry this risk?

Answer 22

No

Question 23

How can firms have negative cash flows and remain solvent?

Answer 23

Through access to capital markets allow to issue new securities.

Question 24

What does bankruptcy do to total value of a firm to investors?

Answer 24

No change but ownership can shift from a firm to equity holders under a perfect capital market.

In reality, complications lead to a slew of direct and indirect costs to firms and investors.

Question 25

What are two forms of bankruptcy protection?

Answer 25

Chapter 7 (Liquidation) and Chapter 11 (Reorganization)

Question 26

Chapter 7 Liquidation Bankruptcy

Answer 26

Trustee is appointment to oversee liquidation of firms assets through an auction. Proceeds are used to paid creditors and cease to exist.

Question 27

Chapter 11 Reorganization Bankruptcy

Answer 27

All collection attempts are suspended - management is given opportunity to reorg the company.

Creditors can receive payments and new debt/equity but must vote to accept the plan (which is approved by a court). Value of cash and securities is lower than what is owed but more than what would be achieved to Chapter 7.

Question 28

What are the direct costs of bankruptcy?

Answer 28

Reducing value of assets to firm’s investors. Usually 3-4% of market value of total assets in direct costs.

Question 29

How can a firm avoid filing for bankruptcy?

Answer 29

Workout: Negotiate directly with investors to reorganize.

Prepack: Reorg plan with investors then file Chapter 11 to implement the plan quickly and avoid time under bankruptcy.

Question 30

What is tradeoff theory?

Answer 30

Firm picks cap structure by trading benefits of tax shield for debt against costs of financial distress.

Question 31

What happens to total value of a levered firm with tradeoff theory?

Answer 31

Equals the value of a firm without leverage plus PV of the tax savings from the debt - PV of financial distress costs.

V; = Vu + PV (Interest Tax Shield) - PV (Financial Distress Costs)

Question 32

What are three factors that determine the present value of financial distress costs?

Answer 32

Probability of financial distress, magnitude of costs after a firm is in distress, discount rate of distress costs.

Question 33

What does tradeoff theory claim on optimal leverage?

Answer 33

Firms should increase their leverage until it reaches the level where the value of the firm is maxmized.

Question 34

What are agency costs?

Answer 34

Costs from conflicts between firm stockholders.

Another cost of increasing firm leverage that affect optimal capital structure.

Question 35

What is a debt overhang or underinvestment problem?

Answer 35

Where equity holders choose not to invest in a positive NPV project because of financial distress and value of taking on investment opportunities benefits bondholders more.

Question 36

Is cashing out a form of underinvestment?

Answer 36

Yes

Question 37

What are two effects on share price when a firm adds leverage to capital structure?

Answer 37

Benefits from equity holder ability to exploit debt holders in distress.

Reducing amount a firm can distribute to shareholders (Debt holders lose more due to lack of repayment)

Question 38

What is management entrenchment?

Answer 38

Separation of ownership and control where managers make decisions on their own interest than those of shareholders.

Leverage allows owners to control their equity stake through concentration of ownership.

Question 39

Free cash flow hypothesis

Answer 39

Wasteful spending more likely to occur when firms have high cashflow in excess of all that is needed for positive NPV investment and payments to deb holders.

Leverage can reduce managerial entrenchment.

Question 40

Marginal tax rate

Answer 40

Tau (t)