How much leverage?

Question 1

What is a tax shield?

Answer 1

Firms with leverage can deduct the interest payment to the bondholders before taxes. This increases the total income to both stockholders and bondholders

Question 2

How do you calculate the tax shield?

Answer 2

Interest times taxrate

Question 3

Who gains when a full equity firm gets leverage? (MV balancesheet)

Answer 3

The equity does not drop as much as the debt gained, the drop in equity is reduced by the PV of tax shields.

Question 4

What is the value of a levered firm in a M.M. setup (1963)

Answer 4

VL=VU+PV(tax shields)=VU+T*D

Question 5

What are the implications for the M.M. 1963 setup?

Answer 5

You can increase leverage to take advantage of lower taxes but you have to take into account the cost of financial distress

Question 6

The trade of theory: what is the formula for the firm value for a firm with leverage?

Answer 6

VL=VU+PV(tax shields)-PV(cost of financial distress)

Question 7

What is the cost of distress formula?

Answer 7

Cost of distress=cost of bankruptcy*probability of bankruptcy

Question 8

How is the probability of bankruptcy affected by an increase in leverage?

Answer 8

The probability of bankruptcy is increased. Higher debt ratios imply higher expected costs of financial distress

Question 9

Draw a graphical representation of the trade of theory with the optimum

Answer 9

Kolla dina bilder, tradeofftheory

Question 10

Explain the cost of financial distress

Answer 10

When a firm is unable, or is expected to be unable to meet its debt obligations it is in financial distress.

Question 11

What are the direct costs of financial distress

Answer 11

legal fees, administrator costs
These direct costs are typically 3% of the firm market value but can be more for smaller firms

Question 12

What are the indirect costs of financial distress?

Answer 12

Costs from losses on asset value in “fire sales”, losses on business opportunities, losses from constraints on conducting business during corporate reorganizations
These indirect costs can be substantial, about 20% of the firm value

Question 13

What firm characteristics determine if the cost of financial distress is high or low?

Answer 13

Growth opportunities, tangible assets, riskiness of cash flow

Question 14

What is the problem with limited liability and risky projects?

Answer 14

Managers have an incentive to take negative NPV projects if indebtness is too high. This can boost the equity value with a cost of debt value.
(Equity holders win and debt holders lose)

Question 15

What can bondholders do if they forsee this

Answer 15

They can impose covenants (veto right for bondholders on investment projects) or require higher intererst payments, hence, a higher cost of capital

Question 16

Why would a manager not take on a positive NPV project? What could be a solution to this problem?

Answer 16

If the project increases firm value but decreases equity value and only increase debt value.
The solution would be to lower leverage or renegotiate debt

Question 17

Why are equity issues bad news?

Answer 17

This has to do with the assymetric information between managers and investors. Investors understand that if a firm issues equity, the managers probably belive that the firm is overvalued. (as soon as a firm issues equity investors react and the share price falls)

Question 18

What is the pecking order?

Answer 18

Use internal funds as much as possible
If external funding is necessary, issue debt first
Equity issues come last