Chapter 16 Flashcards
(40 cards)
What is the interest tax shield?
The reduction in taxes due to the deductibility of interest payments
What happens to the cost of equity as the firm increases leverage?
It increases due to higher financial risk.
When does a capital structure change benefit shareholders?
Only if the total value of the firm increases.
What is the formula for M&M Proposition I with taxes?
What does M&M Proposition II (no taxes) state?
Leverage increases the return and risk to equity holders.
What is homemade leverage?
When investors replicate the effects of corporate leverage on their own.
Why is financial leverage called a double-edged sword?
It magnifies both gains and losses.
What is the cost of equity in a leveraged firm (with taxes)?
What is the risk to shareholders when a firm increases leverage?
Higher earnings volatility and potential for financial distress.
What is the primary benefit of using debt financing?
The interest tax shield.
What does M&M assume about investor behavior in their propositions?
Investors can borrow and lend at the same rate as firms and are rational.
How does leverage affect EPS and ROE during economic expansion?
It increases both EPS and ROE.
What assumptions underlie M&M Proposition I (no taxes)?
No taxes, no bankruptcy costs, and perfect capital markets.
What is ROE sensitive to in a leveraged firm?
Changes in EBIT and the amount of interest expense.
What is financial distress?
A situation where a firm has difficulty meeting its debt obligations, possibly leading to bankruptcy.
What key factor allows debt to add value in a taxed environment?
Interest payments are tax-deductible.
What happens to taxes in a leveraged firm vs. an all-equity firm?
The leveraged firm pays less in taxes, increasing total cash flow to investors.
What is the break-even EBIT in capital structure decisions?
The level of EBIT at which two financing alternatives yield the same EPS.
What is capital structure?
The mix of debt and equity a firm uses to finance its operations.
What is the trade-off theory of capital structure?
Firms balance the tax benefits of debt against the costs of potential financial distress.
How does the interest tax shield affect leveraged firms?
It reduces taxes paid and increases cash flow to investors.
How does leverage affect firm cash flows to investors under M&M with taxes?
It increases after-tax cash flows due to reduced tax payments.
What is the economic interpretation of cutting the pie differently but making it bigger?
Leveraging the firm reduces taxes, increasing total value for shareholders and bondholders.
What is the fundamental reason leverage can make the “pie” bigger?
It reduces the government’s slice through lower taxes.
