Leverage

Question 1

What do we need to consider when considering a project’s incremental financing?

Answer 1

• optimal leverage doesn’t depend only on the project, but also firm-specific characteristics
  -safe cash flows can be 100% debt financed
• a fixed payout policy implies 100% debt financing
• cash is negative debt (net debt = debt - excess cash)

Question 2

True or false: cash is negative debt.

Answer 2

true

Question 3

If a firm doesn’t have the debt-to-equity ratio constant over time, should you use the WACC?

Answer 3

No, we need to follow the APV method which provides more flexibility with respect to more complex capital structure policies

Question 4

True or false: when debt levels are predetermined, the firm has a target leverage ratio (D/V)

Answer 4

False

Question 5

When the firm doesn’t have a target leverage ratio, does the debt tax shields still shares the same risk as the operating assets (unlevered projects)?

Answer 5

No

Question 6

Why can’t we use the standard pre-tax and after-tax WACC equations with the same ease as before when debt levels are predetermined?

Answer 6

The firm won’t have a target leverage ratio, which means the debt tax shields no longer share the same risk as the operating assets (unlevered projects)

Question 7

What is the constant interest coverage ratio?

Answer 7

Constant interest coverage ratio is a policy that entails keeping interest payments equal to a target fraction of free cash flows

Question 8

What is the risk of the tax shield when we have constant interest coverage ratio?

Answer 8

The tax shield moves in lockstep with the FCF. Consequently, the tax shield is as risky as the FCF.

Question 9

True or false: With a constant interest coverage policy, the value of the interest tax shield is proportional to the project’s unlevered value.

Answer 9

True