Chapter 15
What is an interest tax shield, and how does it benefit a firm that uses debt financing?
The interest tax shield is the reduction in income taxes that results from deducting interest payments on debt. It benefits a firm by lowering its taxable income, which, in turn, increases its after-tax cash flow
What is financial distress, and what are some common signs that a company may be experiencing it?
Financial distress occurs when a firm struggles to meet its debt obligations. Common signs include declining cash flows, high levels of debt relative to assets, increased borrowing costs, and lower credit ratings.
How does increasing the amount of debt in a firm’s capital structure affect its overall cost of capital?
Increasing the amount of debt in a firm’s capital structure typically lowers its overall cost of capital due to the tax deductibility of interest.
what is the leverage ratchet effect
Leverage ratchet effect (it’s an agency cost of leverage which affects the firm’s future financing decision rather than investment decision)=> once existing debt is in place, shareholders may have an incentive to increase leverage even if it decreases the value of the firm, and shareholders will not have an incentive to decrease leverage by buying back debt, even if it will increase the value of the firm.
From a tax saving perspective, what is the optimal level of leverage?
the optimal level of leverage from a tax saving perspective is the level such that interest just equals the income limit.
what are the 3 key factors that determine the present value of financial distress costs
- The probability of financial distress
- The magnitude of the costs if the firm is in distress
- The appropriate discount rate for the distress costs
Consider a company that wants to borrow 100,000$ at an interest rate 5%. The Corporate tax rate is 21%. What is the effective after-tax rate?
3,95% or 3,950$
Explain how asymmetric information can impact a firm’s financing decisions. Why might a company prefer to issue debt rather than equity if it believes its shares are undervalued?
The trade-off theory of capital structure suggests that firms balance the benefits of debt (such as the interest tax shield) against the potential costs, such as financial distress and agency costs. While debt financing can increase firm value through tax savings, too much debt increases the risk of financial distress and potential bankruptcy, which can harm the firm's value
ABC inc. is an equity only financed company having 25mio shares outstanding each worth 14$. The firm decides to take on 100mio in debt to repurchase shares. Given a corporate tax rate of 21%, what minimum price does the firm have to offer to repurchase the shares.
14.85$.
VL = (25mio shares * 14$) + tc *100mio = 350mio +21mio = 371mio
371mio / 25mio shares = 14.85$
Consider a firm facing financial distress. Explain how signaling theory might apply if the firm chooses to issue more equity rather than debt. What might this choice indicate to outside investors, and why?
In signaling theory, a firm’s choice to issue equity rather than debt may indicate to investors that management believes the firm’s stock is overvalued. If the firm were confident in its future cash flows and value, it might prefer to issue debt, avoiding the dilution of equity. Therefore, issuing equity during financial distress might signal a lack of confidence in future cash flows, potentially causing the stock price to drop further