Ch. 18: Taxes + Bankruptcy cost

Save this PDF as:
 WORD  PNG  TXT  JPG

Size: px
Start display at page:

Download "Ch. 18: Taxes + Bankruptcy cost"

Transcription

1 Ch. 18: Taxes + Bankruptcy cost If MM1 holds, then Financial Management has little (if any) impact on value of the firm: If markets are perfect, transaction cost (TAC) and bankruptcy cost are zero, no taxation, then finance is easy! But what if the assumptions of MM1 do not hold? 1. If investors pay higher interest rates (imperfect credit markets), then the above examples do not work. 2. If corporate and individual tax rates differ => capital structure may serve as a tax shield. 3. If bankruptcy cost occurs, then capital structure may have incentive effects => agency theory. 261

2 With corporate taxation, the WACC after tax is given by D ra ( at) = rd (1 TC ) + A r E E A where TC is the marginal corporate tax rate. (f the tax rate increases in the tax base, then the marginal tax rate exceeds the average tax rate) 262

3 With corporate taxes, the equity Beta after tax is given by β E ( at ) = β A + ( β A β D )(1 T C ) D E if debt is fixed and permanent, and as long as only corporate tax is considered (see BM 7, ch. 19.6). With changing D, things are more complicated. Multiplication of a random variable with a constant factor (1-TC) implies that its variance has to be multiplied with (1-TC) 2, while its standard deviation as well as its covariance (with an unaffected random variable) are multiplied with (1-TC). 263

4 C.S. & Corporate Taxes: Example You own all the equity of Space Babies Diaper Co.. The company has no debt. The balance sheet shows an asset value (=equity) of $ 2,000. The company s annual cash flow is $1,000, before interest and taxes. The corporate tax rate is 40%. You have the option to exchange 1/2 of your equity for 10% bonds with a face value of $1,000. Should you do this and why? 264

5 All Equity Leveraged (1/2 Debt) EBIT 1,000 1,000 Interest Pmt Pretax Income 1, % Net Cash Flow $600 $540 Total Cash Flow for investors: All Equity => 600 Leveraged => =640 Corporate Tax (on profit/dividends) is reduced, but there is also taxation on personal income (e.g., from interest) 265

6 Capital Structure Turning part of the equity (profit is taxable) into debt (interest rates are deductible) reduces the company s tax burden. In particular this makes sense for the investor s if the MARGINAL corporate tax rate exceeds their personal marginal tax rate on interest earnings. The Tax Shield amounts to D x rd x Tc = 1,000x0.1x0.4=40 in the running period => present value of all future tax shields? Tax shield is a (risky) cash flow, and it is to be discounted at the same rate as as the firm s debt (as this is the interest rate that generates it). 266

7 PV of Tax Shield = (assume perpetuity) D x rd x TC rd = D x TC Thus, the PV is independent of the interest rate Perpetuity = if the firm intends to borrow/use tax shield permanently Tc = corporate tax rate DrD = interest payment Firm Value = Value of an all equity financed firm + PV Tax Shield 267

8 268

9 Capital Structure & Taxes (Personal & Corporate) According to figure 18.1, lending to the firm is better than buying its stock if (1-TP) is greater than (1-TPE)(1-TC), or if the Relative Advantage of Debt over Equity (RADE) 1 - TP (1-TPE) (1-TC) is greater than 1. TP=Personal tax rate on interest earnings TPE=effective personal tax rate on dividends TC=corporate tax rate 269

10 Two special cases: 1. TPE=TP: The relative advantage 1/(1-TC) only depends on (is increasing in) the corporate tax rate. 2. RADE = 1, so debt policy is irrelevant for taxation. <=> 1-TP = 1-TPE-TC+TPETC <=> TP = TPE+(1-TPE)TC <=> TC=(TP-TPE)/(1-TPE), which can only happen if TPE is small and TC<TP. For other cases, the RADE formula seems to give a simple, but useful decision rule. 270

11 RADE empirically in the US (2001) 1.33 (1-.16) (1-.35) =1.23 > 1 Are, hence, all US companies only debt financed? To the contrary, equity is much more popular in the US than in Germany (but the German tax situation since 2008, with the Halbeinkünfteverfahren, is a bit difficult to analyze). => other factors play a role (e.g., bankruptcy risk) 271

12 Capital Structure One possible explanation of this puzzle may lie in the fact that bond yield rates depend on debt ratio (which influences the bankruptcy risk). With a very high bankruptcy risk, rd may even overtake re because debt may become more volatile than equity (the value of a loan depends on the bankruptcy quota). If bankruptcy plays only a minor role, then equity is always more volatile than debt. 272

13 Cost of Financial Distress Costs arising from bankruptcy or distorted business decisions before bankruptcy. Market Value of the firm = Value if all Equity Financed + PV Tax Shield - PV Costs of Financial Distress Next figure: If D=0 (E=A), then tax shield and bankruptcy risk are zero. If D>0 (E<A), then the value of the tax shield increases. But also the bankruptcy risk increases (and, hence, the expected cost of financial distress). This results in a concave curve describing the market value. 273

14 274

15 Financial Distress Games Risk shifting High stakes, high risk (even with negative ENPV) can easily be accepted by managers (or even by investors) under limited liability. Refusing new equity If a company is in distress, investors may be reluctant to buy new shares to finance projects with positive NPV if the returns would primarily go to the bondholders (in case of bankruptcy and even if a success prevents the firm from default). 275

16 Cash In and Run If shareholders are keen to get their money back as long as there is some Playing for Time While bondholders are impatient to settle their claims, shareholders would prefer a delay (accounting steam, using reserves). Bait and Switch Start conservatively, and then continue with aggressive bonds/projects => burdens additional risk on the initial bondholders. 276

17 What is the problem if such games are played among consenting adults? Playing them leads to distortions =>inefficient investment decisions caused by asymmetric information (agency cost). The more a firm borrows, the larger the temptation to play. If investors anticipate this, they will demand a higher rate, the higher the debt ratio. 277

18 Two theories on choice of the debt ratio Trade-off Theory - Capital structure is based on a trade-off between tax savings and distress costs of debt (firms choose capital structure so as to max. firm value for their investors after tax). Pecking Order Theory - Firms prefer to finance new projects by 1. internal sources (retained earnings) 2. debt 3. new equity in that order (Myers 1984, JoFin 39, 581) 278

19 Simple moral hazard problem: Choice of risky projects Lit.: Jensen/Meckling 1976 Entrepreneur/Manager M may choose between two projects: Project X yields either 0 ( bad state, with prob. 1-q) or 200 ( good state, with q) => expected return 200q. Project Y yields -50 (with 1-q) or 300 (with q) => expected return 300q-50(1-q)=350q-50. => Y is more risky than X for each value of q. Both projects require an investment of 20. Manager is promised a share 0<µ<1 of the project returns. Firm s assets=200; it can take up debt at an interest rate of 10%. => before investment: A=200=E if D=0 => after investment, before returns: A=180=E if D=0. 279

20 Which project is preferred by the principal (bank/owner)? ) => normative analysis Which one will, however, be chosen by the agent M? => positive analysis => we distinguish three cases: 1. Unlimited liability on the part of the agent M 2. Limited liability without and with leverage => the principal-agent-problem 3. Limited liability and the debt whip => the solution to the PA-problem 280

21 Normative analysis: What do the shareholders prefer? The expected returns are maximized by chosing Y if 200q<350q-50 <=>150q>50 <=> q>1/3 (which implies 350q-50>20) X if q<1/3 and 200q>20 <=>0.1<q<1/3 none of the projects if q<0.1 (shareholders may have to deduct interest and manager s compensation) Subsequently, we only look at the case 0.1<q<1/3 (e.g., q=1/4) => X is preferred by the SH (if compensation is not too high) => 50-20=30 281

22 Positive analysis 1: What does the manager choose? 1. if he is fully liable 2. if his liability is limited 3. under limited liability and with the debt whip? Positive analysis 1: full liability The manager receives/pays a share µ of all profits/losses If the manager chooses project her expected payoff is X 200µq Y 300µq-50µ(1-q) => Manager s and shareholders interest are perfectly aligned. 282

23 Positive analysis 2: Limited liability The manager receives a share µ of all profits, but has no personal wealth to cover a share of losses If the manager chooses project her expected payoff is X 200µq Y 300µq => Manager always prefers Y. What are the consequences for the shareholders if the manager chooses project Y? => depends on whether or not the firm is levered. 283

24 If the firm is unlevered (E=A=200 => D=0) then, due to the Manager s limited liability, project Y leads to the following positions in the balance sheet: with prob q: A=E= (1-µ)= (1-µ); D=0 with prob (1-q): A=E= =130; D=0 284

25 The levered firm (e.g., E=20, D=180 => interest rate=18) expects the following positions in its balance sheet with prob q: A= (1-µ)-18= µ, D=180 E=300(1-µ)-18 with (1-q): A=130-18=112, D=180, E=-68 => bankruptcy. Assume 300(1-µ)-18>0 <=>1- µ>3/50 µ<47/50 (e.g., µ=0.2) Then: the levered firm goes bankrupt with probability (1-q); and no bankruptcy occurs with probability q. 285

26 Positive analysis 3: Limited liability with a debt whip The manager receives a share µ of all profits, but has no personal wealth; she fears a reputational loss of R in case of a bankruptcy (which occurs with probability 1-q): If the manager chooses project her expected payoff is X 200µq Y 300µq-(1-q)R => She prefers X iff 300µq-(1-q)R<200µq <=> R >100µq/(1-q) => If R is high enough, then manager s and shareholders interest are perfectly aligned. => E.g., with q=0.25 and µ=0.2: R>20/3 (if R=8, then the expected payoff from X is 10; from Y it is 15-6=9) 286

27 Possible incentive effect of debt financing (the debt whip ): Debt creates bankruptcy risk (increases with debt ratio). If managers are bankruptcy averse (e.g., have reputational concerns) then the debt ratio may have an incentive effect. Managers put their reputation at stake (besides income). Alleviates limited liability problem (even with empty pockets, the manager now has something to lose). However, the bankruptcy risk would also hurt the owners. Main lesson here: Leveraging a firm may increase bankruptcy risk (financial instability, in the absence of strategic effects) can even decrease the bankruptcy risk if the debt whip incentivizes the managers to choose the less risky projects (strategic effect). 287

Chapter 17 Corporate Capital Structure Foundations (Sections 17.1 and 17.2. Skim section 17.3.)

Chapter 17 Corporate Capital Structure Foundations (Sections 17.1 and 17.2. Skim section 17.3.) Chapter 17 Corporate Capital Structure Foundations (Sections 17.1 and 17.2. Skim section 17.3.) The primary focus of the next two chapters will be to examine the debt/equity choice by firms. In particular,

More information

CAPITAL STRUCTURE [Chapter 15 and Chapter 16]

CAPITAL STRUCTURE [Chapter 15 and Chapter 16] Capital Structure [CHAP. 15 & 16] -1 CAPITAL STRUCTURE [Chapter 15 and Chapter 16] CONTENTS I. Introduction II. Capital Structure & Firm Value WITHOUT Taxes III. Capital Structure & Firm Value WITH Corporate

More information

t = 1 2 3 1. Calculate the implied interest rates and graph the term structure of interest rates. t = 1 2 3 X t = 100 100 100 t = 1 2 3

t = 1 2 3 1. Calculate the implied interest rates and graph the term structure of interest rates. t = 1 2 3 X t = 100 100 100 t = 1 2 3 MØA 155 PROBLEM SET: Summarizing Exercise 1. Present Value [3] You are given the following prices P t today for receiving risk free payments t periods from now. t = 1 2 3 P t = 0.95 0.9 0.85 1. Calculate

More information

1 Pricing options using the Black Scholes formula

1 Pricing options using the Black Scholes formula Lecture 9 Pricing options using the Black Scholes formula Exercise. Consider month options with exercise prices of K = 45. The variance of the underlying security is σ 2 = 0.20. The risk free interest

More information

Chapter 7: Capital Structure: An Overview of the Financing Decision

Chapter 7: Capital Structure: An Overview of the Financing Decision Chapter 7: Capital Structure: An Overview of the Financing Decision 1. Income bonds are similar to preferred stock in several ways. Payment of interest on income bonds depends on the availability of sufficient

More information

Leverage. FINANCE 350 Global Financial Management. Professor Alon Brav Fuqua School of Business Duke University. Overview

Leverage. FINANCE 350 Global Financial Management. Professor Alon Brav Fuqua School of Business Duke University. Overview Leverage FINANCE 35 Global Financial Management Professor Alon Brav Fuqua School of Business Duke University Overview Capital Structure does not matter! Modigliani & Miller propositions Implications for

More information

Use the table for the questions 18 and 19 below.

Use the table for the questions 18 and 19 below. Use the table for the questions 18 and 19 below. The following table summarizes prices of various default-free zero-coupon bonds (expressed as a percentage of face value): Maturity (years) 1 3 4 5 Price

More information

CHAPTER 13 Capital Structure and Leverage

CHAPTER 13 Capital Structure and Leverage CHAPTER 13 Capital Structure and Leverage Business and financial risk Optimal capital structure Operating Leverage Capital structure theory 1 What s business risk? Uncertainty about future operating income

More information

DUKE UNIVERSITY Fuqua School of Business. FINANCE 351 - CORPORATE FINANCE Problem Set #7 Prof. Simon Gervais Fall 2011 Term 2.

DUKE UNIVERSITY Fuqua School of Business. FINANCE 351 - CORPORATE FINANCE Problem Set #7 Prof. Simon Gervais Fall 2011 Term 2. DUKE UNIVERSITY Fuqua School of Business FINANCE 351 - CORPORATE FINANCE Problem Set #7 Prof. Simon Gervais Fall 2011 Term 2 Questions 1. Suppose the corporate tax rate is 40%, and investors pay a tax

More information

CHAPTER 15 Capital Structure: Basic Concepts

CHAPTER 15 Capital Structure: Basic Concepts Multiple Choice Questions: CHAPTER 15 Capital Structure: Basic Concepts I. DEFINITIONS HOMEMADE LEVERAGE a 1. The use of personal borrowing to change the overall amount of financial leverage to which an

More information

Chapter 17 Does Debt Policy Matter?

Chapter 17 Does Debt Policy Matter? Chapter 17 Does Debt Policy Matter? Multiple Choice Questions 1. When a firm has no debt, then such a firm is known as: (I) an unlevered firm (II) a levered firm (III) an all-equity firm D) I and III only

More information

On the Applicability of WACC for Investment Decisions

On the Applicability of WACC for Investment Decisions On the Applicability of WACC for Investment Decisions Jaime Sabal Department of Financial Management and Control ESADE. Universitat Ramon Llull Received: December, 2004 Abstract Although WACC is appropriate

More information

TPPE17 Corporate Finance 1(5) SOLUTIONS RE-EXAMS 2014 II + III

TPPE17 Corporate Finance 1(5) SOLUTIONS RE-EXAMS 2014 II + III TPPE17 Corporate Finance 1(5) SOLUTIONS RE-EXAMS 2014 II III Instructions 1. Only one problem should be treated on each sheet of paper and only one side of the sheet should be used. 2. The solutions folder

More information

1 (a) Calculation of net present value (NPV) Year 1 2 3 4 5 6 $000 $000 $000 $000 $000 $000 Sales revenue 1,600 1,600 1,600 1,600 1,600

1 (a) Calculation of net present value (NPV) Year 1 2 3 4 5 6 $000 $000 $000 $000 $000 $000 Sales revenue 1,600 1,600 1,600 1,600 1,600 Answers Fundamentals Level Skills Module, Paper F9 Financial Management December 2011 Answers 1 (a) Calculation of net present value (NPV) Year 1 2 3 4 5 6 $000 $000 $000 $000 $000 $000 Sales revenue 1,600

More information

FN2 Ron Muller 2007-08 MODULE 4: CAPITAL STRUCTURE QUESTION 1

FN2 Ron Muller 2007-08 MODULE 4: CAPITAL STRUCTURE QUESTION 1 MODULE 4: CAPITAL STRUCTURE QUESTION 1 Gadget Corp. manufactures gadgets. The average selling price of this finished product is $200 per unit. The variable cost for these units is $125. Gadget Corp. incurs

More information

Chapter 15. Learning Objectives Principles Used in This Chapter 1.A Glance at Capital Structure Choices in Practice 2.Capital Structure Theory

Chapter 15. Learning Objectives Principles Used in This Chapter 1.A Glance at Capital Structure Choices in Practice 2.Capital Structure Theory Chapter 15 Capital Structure Policy Agenda Learning Objectives Principles Used in This Chapter 1.A Glance at Capital Structure Choices in Practice 2.Capital Structure Theory 3.Why Do Capital Structures

More information

Finance 2 for IBA (30J201) F.Feriozzi Resit exam June 14 th, 2011. Part One: Multiple-Choice Questions (45 points)

Finance 2 for IBA (30J201) F.Feriozzi Resit exam June 14 th, 2011. Part One: Multiple-Choice Questions (45 points) Question 1 Finance 2 for IBA (30J201) F.Feriozzi Resit exam June 14 th, 2011 Part One: Multiple-Choice Questions (45 points) Assume that financial markets are perfect and that the market value of a levered

More information

Problem 1 Problem 2 Problem 3

Problem 1 Problem 2 Problem 3 Problem 1 (1) Book Value Debt/Equity Ratio = 2500/2500 = 100% Market Value of Equity = 50 million * $ 80 = $4,000 Market Value of Debt =.80 * 2500 = $2,000 Debt/Equity Ratio in market value terms = 2000/4000

More information

Part 9. The Basics of Corporate Finance

Part 9. The Basics of Corporate Finance Part 9. The Basics of Corporate Finance The essence of business is to raise money from investors to fund projects that will return more money to the investors. To do this, there are three financial questions

More information

STUDENT CAN HAVE ONE LETTER SIZE FORMULA SHEET PREPARED BY STUDENT HIM/HERSELF. FINANCIAL CALCULATOR/TI-83 OR THEIR EQUIVALENCES ARE ALLOWED.

STUDENT CAN HAVE ONE LETTER SIZE FORMULA SHEET PREPARED BY STUDENT HIM/HERSELF. FINANCIAL CALCULATOR/TI-83 OR THEIR EQUIVALENCES ARE ALLOWED. Test III-FINN3120-090 Fall 2009 (2.5 PTS PER QUESTION. MAX 100 PTS) Type A Name ID PRINT YOUR NAME AND ID ON THE TEST, ANSWER SHEET AND FORMULA SHEET. TURN IN THE TEST, OPSCAN ANSWER SHEET AND FORMULA

More information

MM1 - The value of the firm is independent of its capital structure (the proportion of debt and equity used to finance the firm s operations).

MM1 - The value of the firm is independent of its capital structure (the proportion of debt and equity used to finance the firm s operations). Teaching Note Miller Modigliani Consider an economy for which the Efficient Market Hypothesis holds and in which all financial assets are possibly traded (abusing words we call this The Complete Markets

More information

Finance 2 for IBA (30J201) F. Feriozzi Re-sit exam June 18 th, 2012. Part One: Multiple-Choice Questions (45 points)

Finance 2 for IBA (30J201) F. Feriozzi Re-sit exam June 18 th, 2012. Part One: Multiple-Choice Questions (45 points) Finance 2 for IBA (30J201) F. Feriozzi Re-sit exam June 18 th, 2012 Part One: Multiple-Choice Questions (45 points) Question 1 Assume that capital markets are perfect. Which of the following statements

More information

DUKE UNIVERSITY Fuqua School of Business. FINANCE 351 - CORPORATE FINANCE Problem Set #4 Prof. Simon Gervais Fall 2011 Term 2.

DUKE UNIVERSITY Fuqua School of Business. FINANCE 351 - CORPORATE FINANCE Problem Set #4 Prof. Simon Gervais Fall 2011 Term 2. DUK UNIRSITY Fuqua School of Business FINANC 351 - CORPORAT FINANC Problem Set #4 Prof. Simon Gervais Fall 2011 Term 2 Questions 1. Suppose the corporate tax rate is 40%. Consider a firm that earns $1,000

More information

Capital Structure. Itay Goldstein. Wharton School, University of Pennsylvania

Capital Structure. Itay Goldstein. Wharton School, University of Pennsylvania Capital Structure Itay Goldstein Wharton School, University of Pennsylvania 1 Debt and Equity There are two main types of financing: debt and equity. Consider a two-period world with dates 0 and 1. At

More information

U + PV(Interest Tax Shield)

U + PV(Interest Tax Shield) CHAPTER 15 Debt and Taxes Chapter Synopsis 15.1 The Interest Tax Deduction A C-Corporation pays taxes on proits ater interest payments are deducted, but it pays dividends rom ater-tax net income. Thus,

More information

Chapter 14: Capital Structure in a Perfect Market

Chapter 14: Capital Structure in a Perfect Market Chapter 14: Capital Structure in a Perfect Market-1 Chapter 14: Capital Structure in a Perfect Market I. Overview 1. Capital structure: mix of debt and equity issued by the firm to fund its assets Leverage:

More information

1. What is a recapitalization? Why is this considered a pure capital structure change?

1. What is a recapitalization? Why is this considered a pure capital structure change? CHAPTER 12 CONCEPT REVIEW QUESTIONS 1. What is a recapitalization? Why is this considered a pure capital structure change? Recapitalization is an alteration of a company s capital structure to change the

More information

Chapter 15: Debt Policy

Chapter 15: Debt Policy FIN 302 Class Notes Chapter 15: Debt Policy Two Cases: Case one: NO TAX All Equity Half Debt Number of shares 100,000 50,000 Price per share $10 $10 Equity Value $1,000,000 $500,000 Debt Value $0 $500,000

More information

Chapter 7. . 1. component of the convertible can be estimated as 1100-796.15 = 303.85.

Chapter 7. . 1. component of the convertible can be estimated as 1100-796.15 = 303.85. Chapter 7 7-1 Income bonds do share some characteristics with preferred stock. The primary difference is that interest paid on income bonds is tax deductible while preferred dividends are not. Income bondholders

More information

SOLUTIONS. Practice questions. Multiple Choice

SOLUTIONS. Practice questions. Multiple Choice Practice questions Multiple Choice 1. XYZ has $25,000 of debt outstanding and a book value of equity of $25,000. The company has 10,000 shares outstanding and a stock price of $10. If the unlevered beta

More information

University of Pennsylvania The Wharton School

University of Pennsylvania The Wharton School University of Pennsylvania The Wharton School FNCE 100 PROBLEM SET #6 Fall Term 2005 A. Craig MacKinlay Capital Structure 1. The XYZ Co. is assessing its current capital structure and its implications

More information

Paper F9. Financial Management. Fundamentals Pilot Paper Skills module. The Association of Chartered Certified Accountants

Paper F9. Financial Management. Fundamentals Pilot Paper Skills module. The Association of Chartered Certified Accountants Fundamentals Pilot Paper Skills module Financial Management Time allowed Reading and planning: Writing: 15 minutes 3 hours ALL FOUR questions are compulsory and MUST be attempted. Do NOT open this paper

More information

Chapter 1: The Modigliani-Miller Propositions, Taxes and Bankruptcy Costs

Chapter 1: The Modigliani-Miller Propositions, Taxes and Bankruptcy Costs Chapter 1: The Modigliani-Miller Propositions, Taxes and Bankruptcy Costs Corporate Finance - MSc in Finance (BGSE) Albert Banal-Estañol Universitat Pompeu Fabra and Barcelona GSE Albert Banal-Estañol

More information

5Capital Structure II: Stockholder & Bondholder Conflicts

5Capital Structure II: Stockholder & Bondholder Conflicts 5Capital Structure II: Stockholder & Bondholder Conflicts Modigliani-Miller (MM I) theorem If There are no taxes There are no bankruptcy costs The firm s investment policy is fixed Then The value of the

More information

] (3.3) ] (1 + r)t (3.4)

] (3.3) ] (1 + r)t (3.4) Present value = future value after t periods (3.1) (1 + r) t PV of perpetuity = C = cash payment (3.2) r interest rate Present value of t-year annuity = C [ 1 1 ] (3.3) r r(1 + r) t Future value of annuity

More information

Test3. Pessimistic Most Likely Optimistic Total Revenues 30 50 65 Total Costs -25-20 -15

Test3. Pessimistic Most Likely Optimistic Total Revenues 30 50 65 Total Costs -25-20 -15 Test3 1. The market value of Charcoal Corporation's common stock is $20 million, and the market value of its riskfree debt is $5 million. The beta of the company's common stock is 1.25, and the market

More information

FIN 413 Corporate Finance. Capital Structure, Taxes, and Bankruptcy

FIN 413 Corporate Finance. Capital Structure, Taxes, and Bankruptcy FIN 413 Corporate Finance Capital Structure, Taxes, and Bankruptcy Evgeny Lyandres Fall 2003 1 Relaxing the M-M Assumptions E D T Interest payments to bondholders are deductible for tax purposes while

More information

Chapter 17 Capital Structure Limits to the Use of Debt

Chapter 17 Capital Structure Limits to the Use of Debt University of Science and Technology Beijing Dongling School of Economics and management Chapter 17 Capital Structure Limits to the Use of Debt Dec. 2012 Dr. Xiao Ming USTB 1 Key Concepts and Skills Define

More information

Fundamentals Level Skills Module, Paper F9

Fundamentals Level Skills Module, Paper F9 Answers Fundamentals Level Skills Module, Paper F9 Financial Management June 2008 Answers 1 (a) Calculation of weighted average cost of capital (WACC) Cost of equity Cost of equity using capital asset

More information

AFM 372 Fall 2007 Midterm Examination Friday, October 26. This exam has 11 pages including this page. A separate formula sheet will be provided.

AFM 372 Fall 2007 Midterm Examination Friday, October 26. This exam has 11 pages including this page. A separate formula sheet will be provided. Student name: Student number: Instructor: Alan Huang Duration: 2 hours AFM 372 Fall 2007 Midterm Examination Friday, October 26 This exam has 11 pages including this page. A separate formula sheet will

More information

Chapter 16 Financial Distress, Managerial Incentives, and Information

Chapter 16 Financial Distress, Managerial Incentives, and Information Chapter 16 Financial Distress, Managerial Incentives, and Information 16-1. Gladstone Corporation is about to launch a new product. Depending on the success of the new product, Gladstone may have one of

More information

CHAPTER 17 CAPITAL STRUCTURE: LIMITS TO THE USE OF DEBT

CHAPTER 17 CAPITAL STRUCTURE: LIMITS TO THE USE OF DEBT CHAPTER 17 B- 1 CHAPTER 17 CAPITAL STRUCTURE: LIMITS TO THE USE OF DEBT Answers to Concepts Review and Critical Thinking Questions 1. Direct costs are potential legal and administrative costs. These are

More information

Capital Structure: Informational and Agency Considerations

Capital Structure: Informational and Agency Considerations Capital Structure: Informational and Agency Considerations The Big Picture: Part I - Financing A. Identifying Funding Needs Feb 6 Feb 11 Case: Wilson Lumber 1 Case: Wilson Lumber 2 B. Optimal Capital Structure:

More information

MGT201 Solved MCQs(500) By

MGT201 Solved MCQs(500) By MGT201 Solved MCQs(500) By http://www.vustudents.net Why companies invest in projects with negative NPV? Because there is hidden value in each project Because there may be chance of rapid growth Because

More information

Finding the Right Financing Mix: The Capital Structure Decision. Aswath Damodaran 1

Finding the Right Financing Mix: The Capital Structure Decision. Aswath Damodaran 1 Finding the Right Financing Mix: The Capital Structure Decision Aswath Damodaran 1 First Principles Invest in projects that yield a return greater than the minimum acceptable hurdle rate. The hurdle rate

More information

Chapter 7. component of the convertible can be estimated as =

Chapter 7. component of the convertible can be estimated as = Chapter 7 7-1 Income bonds do share some characteristics with preferred stock. The primary difference is that interest paid on income bonds is tax deductible while preferred dividends are not. Income bondholders

More information

THE FINANCING DECISIONS BY FIRMS: IMPACT OF CAPITAL STRUCTURE CHOICE ON VALUE

THE FINANCING DECISIONS BY FIRMS: IMPACT OF CAPITAL STRUCTURE CHOICE ON VALUE IX. THE FINANCING DECISIONS BY FIRMS: IMPACT OF CAPITAL STRUCTURE CHOICE ON VALUE The capital structure of a firm is defined to be the menu of the firm's liabilities (i.e, the "right-hand side" of the

More information

Contribution 787 1,368 1,813 983. Taxable cash flow 682 1,253 1,688 858 Tax liabilities (205) (376) (506) (257)

Contribution 787 1,368 1,813 983. Taxable cash flow 682 1,253 1,688 858 Tax liabilities (205) (376) (506) (257) Answers Fundamentals Level Skills Module, Paper F9 Financial Management June 2012 Answers 1 (a) Calculation of net present value (NPV) As nominal after-tax cash flows are to be discounted, the nominal

More information

University of Waterloo Midterm Examination

University of Waterloo Midterm Examination Student number: Student name: ANONYMOUS Instructor: Dr. Hongping Tan Duration: 1.5 hours AFM 371/2 Winter 2011 4:30-6:00 Tuesday, March 1 This exam has 12 pages including this page. Important Information:

More information

Chapter 13, ROIC and WACC

Chapter 13, ROIC and WACC Chapter 13, ROIC and WACC Lakehead University Winter 2005 Role of the CFO The Chief Financial Officer (CFO) is involved in the following decisions: Management Decisions Financing Decisions Investment Decisions

More information

CORPORATE FINANCE (28C00100)

CORPORATE FINANCE (28C00100) IMPORTANT The submitted exercise answers will be accepted only for those students that have successfully registered for the course lectures. (Please check the list on the course website to make sure your

More information

CHAPTER 20. Hybrid Financing: Preferred Stock, Warrants, and Convertibles

CHAPTER 20. Hybrid Financing: Preferred Stock, Warrants, and Convertibles CHAPTER 20 Hybrid Financing: Preferred Stock, Warrants, and Convertibles 1 Topics in Chapter Types of hybrid securities Preferred stock Warrants Convertibles Features and risk Cost of capital to issuers

More information

Net revenue 785 25 1,721 05 5,038 54 3,340 65 Tax payable (235 58) (516 32) (1,511 56) (1,002 20)

Net revenue 785 25 1,721 05 5,038 54 3,340 65 Tax payable (235 58) (516 32) (1,511 56) (1,002 20) Answers Fundamentals Level Skills Module, Paper F9 Financial Management December 2013 Answers 1 (a) Calculating the net present value of the investment project using a nominal terms approach requires the

More information

Financial Markets and Valuation - Tutorial 6: SOLUTIONS. Capital Structure and Cost of Funds

Financial Markets and Valuation - Tutorial 6: SOLUTIONS. Capital Structure and Cost of Funds Financial Markets and Valuation - Tutorial 6: SOLUTIONS Capital Structure and Cost of Funds (*) denotes those problems to be covered in detail during the tutorial session (*) Problem 1. (Ross, Westerfield

More information

BUS303. Study guide 2. Chapter 14

BUS303. Study guide 2. Chapter 14 BUS303 Study guide 2 Chapter 14 1. An efficient capital market is one in which: A. all securities that investors want are offered. B. all transactions are closed within 2 days. C. current prices reflect

More information

Fundamentals Level Skills Module, Paper F9. Section A. Mean growth in earnings per share = 100 x [(35 7/30 0) 1/3 1] = 5 97% or 6%

Fundamentals Level Skills Module, Paper F9. Section A. Mean growth in earnings per share = 100 x [(35 7/30 0) 1/3 1] = 5 97% or 6% Answers Fundamentals Level Skills Module, Paper F9 Financial Management June 2015 Answers Section A 1 A 2 D 3 D Mean growth in earnings per share = 100 x [(35 7/30 0) 1/3 1] = 5 97% or 6% 4 A 5 D 6 B 7

More information

UNIVERSITY OF WAH Department of Management Sciences

UNIVERSITY OF WAH Department of Management Sciences BBA-330: FINANCIAL MANAGEMENT UNIVERSITY OF WAH COURSE DESCRIPTION/OBJECTIVES The module aims at building competence in corporate finance further by extending the coverage in Business Finance module to

More information

Fundamentals Level Skills Module, Paper F9

Fundamentals Level Skills Module, Paper F9 Answers Fundamentals Level Skills Module, Paper F9 Financial Management June 2009 Answers 1 (a) Weighted average cost of capital (WACC) calculation Cost of equity of KFP Co = 4 0 + (1 2 x (10 5 4 0)) =

More information

CHAPTER 18. Capital Budgeting and Valuation with Leverage. Chapter Synopsis

CHAPTER 18. Capital Budgeting and Valuation with Leverage. Chapter Synopsis CHAPTER 18 Capital Budgeting and Valuation with everage Chapter Synopsis 18.1 Overview of Key Concepts There are three discounted cash flow valuation methods: the weighted average cost of capital (WACC)

More information

Capital Structure II

Capital Structure II Capital Structure II Introduction In the previous lecture we introduced the subject of capital gearing. Gearing occurs when a company is financed partly through fixed return finance (e.g. loans, loan stock

More information

optimum capital Is it possible to increase shareholder wealth by changing the capital structure?

optimum capital Is it possible to increase shareholder wealth by changing the capital structure? 78 technical optimum capital RELEVANT TO ACCA QUALIFICATION PAPER F9 Is it possible to increase shareholder wealth by changing the capital structure? The first question to address is what is meant by capital

More information

Copyright 2009 Pearson Education Canada

Copyright 2009 Pearson Education Canada d) If Dorval calls in the outstanding bonds, a bondholder who currently owns bonds with $100,000 of face value will have to sell them back to the firm at face value. The bonds would be more valuable than

More information

EMBA in Management & Finance. Corporate Finance. Eric Jondeau

EMBA in Management & Finance. Corporate Finance. Eric Jondeau EMBA in Management & Finance Corporate Finance EMBA in Management & Finance Lecture 4: Capital Structure Limits to the Use of Debt Outline 1. Costs of Financial Distress 2. Description of Costs 3. Can

More information

the actions of the party who is insured. These actions cannot be fully observed or verified by the insurance (hidden action).

the actions of the party who is insured. These actions cannot be fully observed or verified by the insurance (hidden action). Moral Hazard Definition: Moral hazard is a situation in which one agent decides on how much risk to take, while another agent bears (parts of) the negative consequences of risky choices. Typical case:

More information

Corporate Finance & Options: MGT 891 Homework #6 Answers

Corporate Finance & Options: MGT 891 Homework #6 Answers Corporate Finance & Options: MGT 891 Homework #6 Answers Question 1 A. The APV rule states that the present value of the firm equals it all equity value plus the present value of the tax shield. In this

More information

- Once we have computed the costs of the individual components of the firm s financing,

- Once we have computed the costs of the individual components of the firm s financing, WEIGHTED AVERAGE COST OF CAPITAL - Once we have computed the costs of the individual components of the firm s financing, we would assign weight to each financing source according to some standard and then

More information

Direccio Financiera II

Direccio Financiera II Direccio Financiera II Year 2014-15 Degree/study: 2013-14- GRAU EMPRESARIAL Course: 3-4 Term: Third Number of ECTS credits: 5 Hours of student s dedication: 125 Language or languages of instruction: English

More information

CHAPTER 14 COST OF CAPITAL

CHAPTER 14 COST OF CAPITAL CHAPTER 14 COST OF CAPITAL Answers to Concepts Review and Critical Thinking Questions 1. It is the minimum rate of return the firm must earn overall on its existing assets. If it earns more than this,

More information

Chapter 14 Assessing Long-Term Debt, Equity, and Capital Structure

Chapter 14 Assessing Long-Term Debt, Equity, and Capital Structure I. Capital Structure (definitions) II. MM without Taxes (1958) III. MM with Taxes (1963) Chapter 14 Assessing Long-Term Debt, Equity, and Capital Structure IV. Financial Distress V. Business Risk VI. Financial

More information

CORPORATE FINANCE REVIEW FOR THIRD QUIZ. Aswath Damodaran

CORPORATE FINANCE REVIEW FOR THIRD QUIZ. Aswath Damodaran CORPORATE FINANCE REVIEW FOR THIRD QUIZ Aswath Damodaran Basic Skills Needed What is the trade off involved in the capital structure choice? Can you estimate the optimal debt ratio for a firm using the

More information

Midterm Exam:Answer Sheet

Midterm Exam:Answer Sheet Econ 497 Barry W. Ickes Spring 2007 Midterm Exam:Answer Sheet 1. (25%) Consider a portfolio, c, comprised of a risk-free and risky asset, with returns given by r f and E(r p ), respectively. Let y be the

More information

WACC and a Generalized Tax Code

WACC and a Generalized Tax Code WACC and a Generalized Tax Code Sven Husmann, Lutz Kruschwitz and Andreas Löffler version from 10/06/2001 ISSN 0949 9962 Abstract We extend the WACC approach to a tax system having a firm income tax and

More information

6. Debt Valuation and the Cost of Capital

6. Debt Valuation and the Cost of Capital 6. Debt Valuation and the Cost of Capital Introduction Firms rarely finance capital projects by equity alone. They utilise long and short term funds from a variety of sources at a variety of costs. No

More information

SAMPLE FACT EXAM (You must score 70% to successfully clear FACT)

SAMPLE FACT EXAM (You must score 70% to successfully clear FACT) SAMPLE FACT EXAM (You must score 70% to successfully clear FACT) 1. What is the present value (PV) of $100,000 received five years from now, assuming the interest rate is 8% per year? a. $600,000.00 b.

More information

LECTURE 07. Cost of Capital Berk, De Marzo Chapter 14 and 15

LECTURE 07. Cost of Capital Berk, De Marzo Chapter 14 and 15 1 LECTURE 07 Cost of Capital Berk, De Marzo Chapter 14 and 15 2 Equity Versus Debt Financing Capital Structure: The relative proportions of debt, equity, and other securities that a firm has outstanding.

More information

The Debt-Equity Trade Off: The Capital Structure Decision

The Debt-Equity Trade Off: The Capital Structure Decision The Debt-Equity Trade Off: The Capital Structure Decision Aswath Damodaran Stern School of Business Aswath Damodaran 1 First Principles Invest in projects that yield a return greater than the minimum acceptable

More information

Principles of Corporate Finance

Principles of Corporate Finance Principles of Corporate Finance Chapter 18. Does debt policy matter? Ciclo Profissional 2 o Semestre / 2009 Graduaccão em Ciências Econômicas V. Filipe Martins-da-Rocha (FGV) Principles of Corporate Finance

More information

CHAPTER 16. Financial Distress, Managerial Incentives, and Information. Chapter Synopsis

CHAPTER 16. Financial Distress, Managerial Incentives, and Information. Chapter Synopsis CHAPTER 16 Financial Distress, Managerial Incentives, and Information Chapter Synopsis In the previous two chapters it was shown that, in an otherwise perfect capital market in which firms pay taxes, the

More information

Chapter 14 Capital Structure in a Perfect Market

Chapter 14 Capital Structure in a Perfect Market Chapter 14 Capital Structure in a Perfect Market 14-1. Consider a project with free cash flows in one year of $130,000 or $180,000, with each outcome being equally likely. The initial investment required

More information

Jeffrey F. Jaffe Spring Semester 2016 Corporate Finance FNCE 100 Syllabus, page 1. Spring 2016 Corporate Finance FNCE 100 Wharton School of Business

Jeffrey F. Jaffe Spring Semester 2016 Corporate Finance FNCE 100 Syllabus, page 1. Spring 2016 Corporate Finance FNCE 100 Wharton School of Business Corporate Finance FNCE 100 Syllabus, page 1 Spring 2016 Corporate Finance FNCE 100 Wharton School of Business Syllabus Course Description: This course provides an introduction to the theory, the methods,

More information

The cost of capital. A reading prepared by Pamela Peterson Drake. 1. Introduction

The cost of capital. A reading prepared by Pamela Peterson Drake. 1. Introduction The cost of capital A reading prepared by Pamela Peterson Drake O U T L I N E 1. Introduction... 1 2. Determining the proportions of each source of capital that will be raised... 3 3. Estimating the marginal

More information

THE IMPACT OF INVESTMENT STRATEGY ON THE MARKET VALUE AND PRICING DECISIONS OF A PROPERTY/CASUALTY INSURER. Abstract

THE IMPACT OF INVESTMENT STRATEGY ON THE MARKET VALUE AND PRICING DECISIONS OF A PROPERTY/CASUALTY INSURER. Abstract THE IMPACT OF INVESTMENT STRATEGY ON THE MARKET VALUE AND PRICING DECISIONS OF A PROPERTY/CASUALTY INSURER TRENT R. VAUGHN Abstract This paper examines the impact of investment strategy on the market value

More information

BF 6701 : Financial Management Comprehensive Examination Guideline

BF 6701 : Financial Management Comprehensive Examination Guideline BF 6701 : Financial Management Comprehensive Examination Guideline 1) There will be 5 essay questions and 5 calculation questions to be completed in 1-hour exam. 2) The topics included in those essay and

More information

Taxable cash flow 556 1,485 1,530 2,308 Taxation (167) (446) (459) (692) CA tax benefits

Taxable cash flow 556 1,485 1,530 2,308 Taxation (167) (446) (459) (692) CA tax benefits Answers Fundamentals Level Skills Module, Paper F9 Financial Management June 2011 Answers 1 (a) Net present value evaluation of new confectionery investment Year 1 2 3 4 5 $000 $000 $000 $000 $000 Sales

More information

Chapter 10 Risk and Capital Budgeting

Chapter 10 Risk and Capital Budgeting Chapter 10 Risk and Capital Budgeting MULTIPLE CHOICE 1. Operating leverage describes the relationship between... a. EBIT and sales b. taxes and sales c. debt and equity d. fixed costs and variable costs

More information

Cost of Capital and Project Valuation

Cost of Capital and Project Valuation Cost of Capital and Project Valuation 1 Background Firm organization There are four types: sole proprietorships partnerships limited liability companies corporations Each organizational form has different

More information

Source of Finance and their Relative Costs F. COST OF CAPITAL

Source of Finance and their Relative Costs F. COST OF CAPITAL F. COST OF CAPITAL 1. Source of Finance and their Relative Costs 2. Estimating the Cost of Equity 3. Estimating the Cost of Debt and Other Capital Instruments 4. Estimating the Overall Cost of Capital

More information

The Assumptions and Math Behind WACC and APV Calculations

The Assumptions and Math Behind WACC and APV Calculations The Assumptions and Math Behind WACC and APV Calculations Richard Stanton U.C. Berkeley Mark S. Seasholes U.C. Berkeley This Version October 27, 2005 Abstract We outline the math and assumptions behind

More information

The Tangent or Efficient Portfolio

The Tangent or Efficient Portfolio The Tangent or Efficient Portfolio 1 2 Identifying the Tangent Portfolio Sharpe Ratio: Measures the ratio of reward-to-volatility provided by a portfolio Sharpe Ratio Portfolio Excess Return E[ RP ] r

More information

Homework Assignment #1: Answer Key

Homework Assignment #1: Answer Key Econ 497 Economics of the Financial Crisis Professor Ickes Spring 2012 Homework Assignment #1: Answer Key 1. Consider a firm that has future payoff.supposethefirm is unlevered, call the firm and its shares

More information

GESTÃO FINANCEIRA II PROBLEM SET 5 SOLUTIONS (FROM BERK AND DEMARZO S CORPORATE FINANCE ) LICENCIATURA UNDERGRADUATE COURSE

GESTÃO FINANCEIRA II PROBLEM SET 5 SOLUTIONS (FROM BERK AND DEMARZO S CORPORATE FINANCE ) LICENCIATURA UNDERGRADUATE COURSE GESTÃO FINANCEIRA II PROBLEM SET 5 SOLUTIONS (FROM BERK AND DEMARZO S CORPORATE FINANCE ) LICENCIATURA UNDERGRADUATE COURSE 1 ST SEMESTER 2010-2011 Chapter 18 Capital Budgeting and Valuation with Leverage

More information

Final Exam MØA 155 Financial Economics Fall 2009 Permitted Material: Calculator

Final Exam MØA 155 Financial Economics Fall 2009 Permitted Material: Calculator University of Stavanger (UiS) Stavanger Masters Program Final Exam MØA 155 Financial Economics Fall 2009 Permitted Material: Calculator The number in brackets is the weight for each problem. The weights

More information

Chapter 2: Agency costs and the amount of leverage

Chapter 2: Agency costs and the amount of leverage Chapter 2: Agency costs and the amount of leverage Corporate Finance - MSc in Finance (BGSE) Albert Banal-Estañol Universitat Pompeu Fabra and Barcelona GSE Albert Banal-Estañol (UPF and BGSE) Chapter

More information

Finding the Right Financing Mix: The Capital Structure Decision

Finding the Right Financing Mix: The Capital Structure Decision Finding the Right Financing Mix: The Capital Structure Decision Aswath Damodaran Stern School of Business Aswath Damodaran 1 First Principles Invest in projects that yield a return greater than the minimum

More information

INTERVIEWS - FINANCIAL MODELING

INTERVIEWS - FINANCIAL MODELING 420 W. 118th Street, Room 420 New York, NY 10027 P: 212-854-4613 F: 212-854-6190 www.sipa.columbia.edu/ocs INTERVIEWS - FINANCIAL MODELING Basic valuation concepts are among the most popular technical

More information

MBA Financial Management and Markets Exam 1 Spring 2009

MBA Financial Management and Markets Exam 1 Spring 2009 MBA Financial Management and Markets Exam 1 Spring 2009 The following questions are designed to test your knowledge of the fundamental concepts of financial management structure [chapter 1], financial

More information

Discount rates for project appraisal

Discount rates for project appraisal Discount rates for project appraisal We know that we have to discount cash flows in order to value projects We can identify the cash flows BUT What discount rate should we use? 1 The Discount Rate and

More information

What Do Short-Term Liquidity Ratios Measure? What Is Working Capital? How Is the Current Ratio Calculated? How Is the Quick Ratio Calculated?

What Do Short-Term Liquidity Ratios Measure? What Is Working Capital? How Is the Current Ratio Calculated? How Is the Quick Ratio Calculated? What Do Short-Term Liquidity Ratios Measure? What Is Working Capital? HOCK international - 2004 1 HOCK international - 2004 2 How Is the Current Ratio Calculated? How Is the Quick Ratio Calculated? HOCK

More information

Leverage and Capital Structure

Leverage and Capital Structure Leverage and Capital Structure Ross Chapter 16 Spring 2005 10.1 Leverage Financial Leverage Financial leverage is the use of fixed financial costs to magnify the effect of changes in EBIT on EPS. Fixed

More information