Week 6

Question 1

Why can leverage affect the value of firms in imperfect markets?

Answer 1

In imperfect markets firms get a tax benefit from interest payments which can increase the value of the company.

Question 2

How does financial distress occur in relation to debt?

Answer 2

Debt provides tax benefits to the firm, but also puts pressure on the firm in the form of interest and principal payment obligations. If there are not met the firm may risk financial distress, in the worst case leading to bankruptcy.

Question 3

What costs are involved in bankruptcy?

Answer 3

The two costs of bankruptcy are the direct costs, which are the legal and administrative costs of liquidation and reorganization, and indirect costs, such an an impaired ability to conduct business, e.d due to the lowered reputation.

Question 4

what occurs to the debt value of a company if they cannot pay their debt?

Answer 4

When calculating the value of a firm’s cash flow when it has lower cash flows + reserves than required to pay their debt we must factor in that the debt value will be lower, and there will be bankruptcy costs which affect the firm value.

Question 5

How do debt holders deal with bankruptcy risk? Who bears the bankruptcy cost?

Answer 5

Debt holders expect a certain return and factor in bankruptcy costs, this means they will required higher returns in a world with bankruptcy costs. Shareholders are the party who much bear this bankruptcy cost as bond holders simply increase their required return.

Question 6

How do agency costs relate to firm leverage?

Answer 6

Agency costs increase with leverage, when a firm has debt, conflicts of interest arise between stockholders and bondholders, these magnify when financial distress is incurred, increasing agency costs.

Question 7

What are three major agency costs of debt in relation to financial distress?

Answer 7

Stockholders have an incentive to take large risks when in financial distress, incentive toward underinvestment, milking the property.

Question 8

Why are stockholders incentivised to take large risks when in financial distress?

Answer 8

Stockholders have an incentive to take large risks when in financial distress, such as investing in risky negative-NPV projects which will destroy value for bondholders and the firm overall (in the hopes that they get lucky and generate a huge return).

This occurs because the investors may be left nothing in a bad/neutral scenario anyways due to interest payments, but with the risky scenario if they are lucky they will receive far more than if they didn’t take the risk.
Overall, this risky manoeuvre increases the value of equity at the cost of the value of debt and total value.

Question 9

Why are stockholders incentivised to underinvest when in financial distress?

Answer 9

Stockholders of a firm with a significant probability of bankruptcy often find that new investment which require stockholders supply additional funds will help the bondholders at the stockholders expense, as the profits will first have to go to paying off bondholders.

Question 10

What is milking the property?

Answer 10

In milking the property companies may pay out extra dividends in times of financial distress, leaving less in the firm for bondholders (withdrawing equity through dividend).

Question 11

What is a protective covenant? How do they affect firm value?

Answer 11

Bondholders require higher interest rates as insurance against selfish shareholder strategies. Shareholders however want to make agreements with bondholders in hope of lowering these rates. These agreements are known as protective covenants.

Protective covenants act to reduce the costs of financial distress, and hence increase the value of the firm.

Question 12

What are the two types of protective covenants?

Answer 12

A protective covenant could be positive, these specify actions the firm agrees to take/abide to, such as maintaining working capital at a minimum level, or furnishing periodic financial statements to lender.

Negative covenants limit or prohibit actions the company may take, e.g, limiting the amount of dividend, limiting sale of assets, limiting mergers (they can be used to increase leverage), or issuance of additional long term debt.

Question 13

How does the trade-off theory of capital structure work?

What is the value of a levered firm under this theory?

Answer 13

There is a trade-off between the tax advantage of debt and financial distress costs. The optimal capital structure will maximize the firm value, and hence, minimize the cost of capital. This is known as the trade-off theory of capital structure.

When corporate taxes are considered, the theory suggests that the value of the leverd firm is:

Value of levered firm = value of unlevered firm + tax rate * debt - (present value of financial distress costs from the increase in debt to equity ratio).

This means the optimal capital structure is the debt/equity ratio where the marginal tax shield gain of extradebt is equal to the increment in the present value of financial distress costs.

Question 14

What will the present value of financial distress costs be in relation to the M&M irrelevance theory and the trade-off theory?

Answer 14

The present value of the financial distress costs will be the difference between the M&M irrelevance theory with corporate taxes value of the levered firm and the actual value of the firm under trade-off theory.

Question 15

What is the agency cost of equity? How can it affect debt-equity financing?

Answer 15

The agency cost of equity on debt-equity financing refers to how an individual will work harder for a firm if they are one of the owners, rather than only hired, and will work even harder if they own a larger percentage. This means someone with a large share in the company may be more inclined to use debt as it may make their cash flows larger due to the higher stake, if they use equity this cash flow will be diluted.

Issuing stock may also lead to a previously private owner becoming a manager, and hence being more likely to want perquisites, shirk responsibilities, and take negative NPV projects to raise firm size (managerial salaries rise with firm size).

Hence, overall, as firms issue more equity, agency costs can increase.

Question 16

What is the free cash flow hypothesis? What is the value of the firm in this case?

Answer 16

The free cash flow hypothesis argures that an increase in dividends should benefit stockholders by reducing the ability of managers to pursue wasteful activities. It also argues an increase in debt reduces the ability of managers to pursue wasteful activities more effectively than increasing dividends.

Value of firm = unlevered firm value + tax shield on debt +reduction in agency cost of equity - increase in the cost of financial distress.

Question 17

What are the advantages and disadvantages of debt for firm value?

Answer 17

Advantages of debt for firm value: Tax benefits (Higher tax rate, greater benefit), reduced agency costs of equity (as separation of stockholders and managers increases, the benefit increases).
Disadvantages of debt for firm value: Expected bankruptcy costs (for any given level of earnings, firms with more stable earnings and/or lower bankruptcy costs should borrow more), agency costs of debt ( firms where lenders can monitor/control how their money is used should borrow more).

Question 18

How much income does an individual receive from interest and equity?

Answer 18

equity income faces taxation at the firm level and at the shareholder level, hence a stockholder receives (1-corporate tax) * (1-tax personal on equity income).

Interest payments however are only taxed at the individual level and hence (1-personal tax on bond income).

Question 19

What is the value of a firm under the Miller model? What does this mean for our preferred source of financing? Does it incorporate financial distress and agency costs? How will this affect the result?

Answer 19

Under the Miller model, the value of a levered firm is:

Value levered = value unlevered + (1-((1-corporate tax)(1-personal tax on equity))/(1-personal tax on bond income))debt.
Hence, the preferred source of financings depends on the comparison between (1-personal bond income tax rate) and (1-corporate tax)*(1-personal tax on equity income.

There are two special cases. If the tax rate for personal equity income is the same as personal bond income, we get M&M with corporate taxes.
If (1-corporate tax)*(1-personal tax on equity income) = (1-personal tax rate for bond income), then the gain from leverage is 0, the same as in the M&M with no-tax case.

If we incorporate the financial distress costsa and agency costs the value of the levered firm will have a curved shape.

Question 20

What personal tax rate should firm’s assume for their value in the real world?

Answer 20

Individuals typically case different tax rates, there is no simple answer to which taxpayer rate should determine the value of the firm, though the general consensus is that a classical tax system which changing tax rate will still favour corporate debt.

Question 21

How does an imputation system affect company value?

Answer 21

By integrating an imputation system we make it so there is not any taxation difference between debt and equity income for investors, however, there are some investor groups this is not true for. In this case the corporate tax rate becomes effectively zero, making the gain from company debt:
G = (1-((1-equity tax rate)/(1-debt tax rate))*B).

Typically, the equity and debt income tax rates will be the same, as there is now no tax advantage for debt the choice of capital structure should not affect the firm. Though other results may be possible if profits are retained or investors are tax exempt.

Question 22

What is the pecking-order theory of capital structure?

Answer 22

In the pecking order theory of capital structure tax is not particularly important, instead, it assumes managers act in the interest of existing shareholders (not selling undervalued securities), it also assumes information asymmetry, that investors do not know the true value of either the existing assets to the new opportunity but managers do.

The pecking-order theory applies when a firm has assets-in-place and a growth opportunity that requires additional financing.

Question 23

What occurs to share price under the pecking-order theory of capital structure if the firm issues shares?
What if firms use debt?

Answer 23

Under the pecking-order theory of capital structure: if the firm announces an issue oforidnary shares it may be good news if investors believe there are good projects, or bad news if they think management is selling overvalued shares, this causes investors to mark down the share price. As such manages of an undervalued firm will not issue new shares, only overvalues firms to coutneract this effect.
The evidence of this is the average fall being about 3%.

If firms use debt there will be a smaller impact on share price than with equity issuance.

Question 24

What are the main points of the pecking-order theory?

Answer 24

• Firms prefer internal to external finance.
• If external funds are required debt is issued first because it is safer.
• If internal cash flows exceed capital investment the surplus is used to pay down debt rather than repurchasing and retiring equity, Hnece, more profitable firms should issue less debt.
• Each firm’s debt ratio reflects its cumulative requirement for external financing.

Question 25

What is the real world capital structure of firms typically given by?

Answer 25

In the real world the capital structure of firms is typically:

• Most non-financial corporations have low debt-asset ratios.
• Changes in financial leverage do affect firm value (more debt means firms believe they will be able to meet obligations).
• A number of firms use no debt.
• There are differences in capital structure across industries and even through time.
• There is evidence that firms behave as if they had a target debt-equity ratio.

Question 26

What factors are there typically in a target debt to equity ratio?

Answer 26

The factors of a target debt to equity ratio are typically: taxes, types of assets (liquid assets mean more borrowing), and uncertainty of operating income.

Question 27

What are some of the main differentiations of the pecking order theory and the trade-off theory?

Answer 27

The pecking order theory differs with the trade-off theory in that: There is no target debt to equity ratio, profitable firms use less debt, and companies like financial leeway (cash availability).