1、Chapter 18 - How Much Should a Corporation Borrow?18-1CHAPTER 18How Much Should a Corporation Borrow?Answers to Problem Sets1. The calculation assumes that the tax rate is fixed, that debt is fixed and perpetual, and that investors personal tax rates on interest and equity income are the same.2. a.
2、PV tax shield = TcD = $16.b. Tc X 20 = $8.3.Relative advantage of debt = cpET1= 0.65.Relative advantage = 1884. A firm with no taxable income saves no taxes by borrowing and paying interest. The interest payments would simply add to its tax-loss carry-forwards. Such a firm would have little tax ince
3、ntive to borrow.5. a. Direct costs of financial distress are the legal and administrative costs of bankruptcy. Indirect costs include possible delays in liquidation (Eastern Airlines) or poor investment or operating decisions while bankruptcy is being resolved. Also the threat of bankruptcy can lead
4、 to costs.b. If financial distress increases odds of default, managers and shareholders incentives change. This can lead to poor investment or financing decisions.c. See the answer to 5(b). Examples are the “games” described in Section 18-3.6. Not necessarily. Announcement of bankruptcy can send a m
5、essage of poor Chapter 18 - How Much Should a Corporation Borrow?18-2profits and prospects. Part of the share price drop can be attributed to anticipated bankruptcy costs, however.7. More profitable firms have more taxable income to shield and are less likely to incur the costs of distress. Therefor
6、e the trade-off theory predicts high (book) debt ratios. In practice the more profitable companies borrow least.8. Debt ratios tend to be higher for larger firms with more tangible assets. Debt ratios tend to be lower for more profitable firms with higher market-to-book ratios.9. When a company issu
7、es securities, outside investors worry that management may have unfavorable information. If so the securities can be overpriced. This worry is much less with debt than equity. Debt securities are safer than equity, and their price is less affected if unfavorable news comes out later.A company that c
8、an borrow (without incurring substantial costs of financial distress) usually does so. An issue of equity would be read as “bad news” by investors, and the new stock could be sold only at a discount to the previous market price.10. a. The cumulative requirement for external financing. b. More profit
9、able firms can rely more on internal cash flow and need less external financing.11. Financial slack is most valuable to growth companies with good but uncertain investment opportunities. Slack means that financing can be raised quickly for positive-NPV investments. But too much financial slack can t
10、empt -mature companies to overinvest. Increased borrowing can force such firms to pay out cash to investors.12. a. $25.931.08,).35(r1D)(Tild)(tx Cb. .shiel)PV(ta 51).(,$.0t tc. PV(tax shield) = TC D = $35013. For $1 of debt income:Chapter 18 - How Much Should a Corporation Borrow?18-3Corporate tax =
11、$0Personal tax = 0.35 $1 = $0.350Total = $0.350For $1 of equity income, with all capital gains realized immediately:Corporate tax =0.35 $1 = $0.350Personal tax = 0.35 0.5 $1 (0.35$1) + 0.15 0.5 $1 (0.35$1) =$0.163Total = $0.513For $1 of equity income, with all capital gains deferred forever:Corporat
12、e tax =0.35 $1 = $0.350Personal tax = 0.35 0.5 $1 (0.35$1) = $0.114Total = $0.46414. Consider a firm that is levered, has perpetual expected cash flow X, and has an interest rate for debt of rD. The personal and corporate tax rates are Tp and Tc, respectively. The cash flow to stockholders each year
13、 is:(X - rDD)(1 - Tc)(1 - Tp)Therefore, the value of the stockholders position is:where r is the opportunity cost of capital for an all-equity-financed firm. If the stockholders borrow D at the same rate rD, and invest in the unlevered firm, their cash flow each year is:The value of the stockholders
14、 position is then:The difference in stockholder wealth, for investment in the same assets, is:VL VU = DTc)T(1r)()(1rX)VpDcpcL )()T(r) cpcL)T(1)rT(1)(Xppc )(r)(r)VpDpcU)T(1rX)pcChapter 18 - How Much Should a Corporation Borrow?18-4This is the change in stockholder wealth predicted by MM.If individual
15、s could not deduct interest for personal tax purposes, then:Then:So the value of the shareholders position in the levered firm is relatively greater when no personal interest deduction is allowed.15. Long-term debt increases by: $10,000 $4,943 = $5,057 millionThe corporate tax rate is 35%, so firm v
16、alue increases by:0.35 $3,874 = $1,770 millionThe market value of the firm is now: $79,397 + $1,770 = $81,167 millionThe market value balance sheet is:Net working capital $4986 $10,000 Long-term debtPV interest tax shield 3500 10,175 Other long-term liabilitiesLong-term assets 72,681 60,992 EquityTo
17、tal Assets $81,167 $81,167 Total value16. Assume the following facts for Circular File:Book ValuesNet working capital $20 $50 Bonds outstandingFixed assets 80 50 Common stockTotal assets $100 $100 Total valueMarket ValuesNet working capital $20 $25 Bonds outstandingFixed assets 10 5 Common stockTota
18、l assets $30 $30 Total valuea. Playing for TimeSuppose Circular File foregoes replacement of $10 of capital equipment, so that the new balance sheet may appear as follows:)T(1rD)T(1rX)VppcU)(rDpcL )T(1)(VpcULChapter 18 - How Much Should a Corporation Borrow?18-5Market ValuesNet working capital $30 $
19、29 Bonds outstandingFixed assets 8 9 Common stockTotal assets $38 $38 Total valueHere the shareholder is better off but has obviously diminished the firms competitive ability.b. Cash In and RunSuppose the firm pays a $5 dividend:Market ValuesNet working capital $15 $23 Bonds outstandingFixed assets
20、10 2 Common stockTotal assets $25 $25 Total valueHere the value of common stock should have fallen to zero, but the bondholders bear part of the burden.c. Bait and SwitchMarket ValuesNet working capital $30 $20 New Bonds outstanding20 Old Bonds outstandingFixed assets 20 10 Common stockTotal assets
21、$50 $50 Total value17. Answers here will vary according to the companies chosen; however, the important considerations are given in the text, Section 19.3.18. a. Stockholders win. Bond value falls since the value of assets securing the bond has fallen.b. Bondholder wins if we assume the cash is left
22、 invested in Treasury bills. The bondholder is sure to get $26 plus interest. Stock value is zero because there is no chance that the firm value can rise above $50.c. The bondholders lose. The firm adds assets worth $10 and debt worth $10. This would increase Circulars debt ratio, leaving the old bo
23、ndholders more exposed. The old bondholders loss is the stockholders gain.d. Both bondholders and stockholders win. They share the (net) increase in firm value. The bondholders position is not eroded by the issue of a junior security. (We assume that the preferred does not lead to still Chapter 18 -
24、 How Much Should a Corporation Borrow?18-6more game playing and that the new investment does not make the firms assets safer or riskier.)e. Bondholders lose because they are at risk for a longer time. Stockholders win.19. a. SOS stockholders could lose if they invest in the positive NPV project and
25、then SOS becomes bankrupt. Under these conditions, the benefits of the project accrue to the bondholders.b. If the new project is sufficiently risky, then, even though it has a negative NPV, it might increase stockholder wealth by more than the money invested. This is a result of the fact that, for
26、a very risky investment, undertaken by a firm with a significant risk of default, stockholders benefit if a more favorable outcome is actually realized, while the cost of unfavorable outcomes is borne by bondholders.c. Again, think of the extreme case: Suppose SOS pays out all of its assets as one l
27、ump-sum dividend. Stockholders get all of the assets, and the bondholders are left with nothing. (Note: fraudulent conveyance laws may prevent this outcome)20. a. The bondholders may benefit. The fine print limits actions that transfer wealth from the bondholders to the stockholders.b. The stockhold
28、ers may benefit. In the absence of fine print, bondholders charge a higher rate of interest to ensure that they receive a fair deal. The firm would probably issue the bond with standard restrictions. It is likely that the restrictions would be less costly than the higher interest rate.21. Other thin
29、gs equal, the announcement of a new stock issue to fund an investment project with an NPV of $40 million should increase equity value by $40 million (less issue costs). But, based on past evidence, management expects equity value to fall by $30 million. There may be several reasons for the discrepan
30、cy:(i) Investors may have already discounted the proposed investment. (However, this alone would not explain a fall in equity value.)(ii) Investors may not be aware of the project at all, but they may believe instead that cash is required because of, say, low levels of operating cash flow.(iii) Inve
31、stors may believe that the firms decision to issue equity rather than debt signals managements belief that the stock is overvalued.If the stock is indeed overvalued, the stock issue merely brings forward a stock price decline that will occur eventually anyway. Therefore, the fall in value is not Cha
32、pter 18 - How Much Should a Corporation Borrow?18-7an issue cost in the same sense as the underwriters spread. If the stock is not overvalued, management needs to consider whether it could release some information to convince investors that its stock is correctly valued, or whether it could finance
33、the project by an issue of debt.22. a. Masulis results are consistent with the view that debt is always preferable because of its tax advantage, but are not consistent with the tradeoff theory, which holds that management strikes a balance between the tax advantage of debt and the costs of possible
34、financial distress. In the tradeoff theory, exchange offers would be undertaken to move the firms debt level toward the optimum. That ought to be good news, if anything, regardless of whether leverage is increased or decreased.b. The results are consistent with the evidence regarding the announcemen
35、t effects on security issues and repurchases.c. One explanation is that the exchange offers signal managements assessment of the firms prospects. Management would only be willing to take on more debt if they were quite confident about future cash flow, for example, and would want to decrease debt if
36、 they were concerned about the firms ability to meet debt payments in the future.23. a.Expected Payoff to Bank Expected Payoff to Ms. KetchupProject 1 +10.0 +5Project 2 (0.410) + (0.60) = +4.0 (0.414) + (0.60)=+5.6Ms. Ketchup would undertake Project 2.b. Break even will occur when Ms. Ketchups expec
37、ted payoff from Project 2 is equal to her expected payoff from Project 1. If X is Ms. Ketchups payment on the loan, then her payoff from Project 2 is:0.4 (24 X)Setting this expression equal to 5 (Ms. Ketchups payoff from Project 1), and solving, we find that: X = 11.5Therefore, Ms. Ketchup will borr
38、ow less than the present value of this payment.24. One advantage of setting debt-equity targets based on bond ratings is that firms may minimize borrowing costs. This is especially true of bond covenants establish lower ratings as a condition of default. One disadvantage is that firms may not take f
39、ull advantage of tax benefits from debt financing if they refuse to borrow amounts they could finance with relative safety.Chapter 18 - How Much Should a Corporation Borrow?18-825. The right measure in principle is the ratio derived from market-value balance sheets. Book balance sheets represent his
40、torical values for debt and equity which can be significantly different from market values. Any changes in capital structure are made at current market values.The trade-off theory proposes to explain market leverage. Increases or decreases in debt levels take place at market values. For example, a d
41、ecision to reduce the likelihood of financial distress by retirement of debt means that existing debt is acquired at market value, and that the resulting decrease in interest tax shields is based on the market value of the retired debt. Similarly, a decision to increase interest tax shields by incre
42、asing debt requires that new debt be issued at current market prices.Similarly, the pecking-order theory is based on market values of debt and equity. Internal financing from reinvested earnings is equity financing based on current market values; the alternative to increased internal financing is a
43、distribution of earnings to shareholders. Debt capacity is measured by the current market value of debt because the financial markets view the amount of existing debt as the payment required to pay off that debt.26. If it was always possible to issue stock quickly and use the additional proceeds to
44、repurchase debt, then firms may indeed avoid financial distress. But potential equity investors may be reluctant to buy stock in a firm if adverse market events are likely to place the bonds in default: they would effectively be putting money into a sinking ship, and those proceeds would go to repay
45、 the senior bond claims in bankruptcy. This is especially true if the bonds quickly move into default (or if there are cross-default provisions where one bond series default triggers other defaults).In some cases, bondholders may recognize that the firm has greater value as a going concern and agree to take a haircut on interest payments in exchange for an equity infusion. Under these circumstances, a firm may indeed be able to raise additional equitybut the negotiations and gamesmanship of these workout situations can get tricky.
