Capital Structure Questions

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Daniela Franklin
6 years ago
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Capital Structure Questions What do you think?

Large firms More tangible assets More lower risk; better access to capital

market/book equity Less more growth options Unemployment has decreased and

Firms in your industry should (increase/decrease) debt?

1 Capital Structure Questions What do you think? Will the following firm characteristics result in the use of more or less debt? Large firms More tangible assets More lower risk; better access to capital markets More Theory & Practice More stable profits over time More Higher market/book equity Less more growth options Unemployment has decreased and there is a labor shortage within your industry. Firms in your industry should (increase/decrease) debt? Decrease debt Because of customer quality concerns, your automotive firm has decided to offer 5-year, 100,000 mile warranties in place of 2-year 24,000 mile warranties Decrease Debt 1

Which firm should use more debt. Wendy s Inc.

years Increase Debt The corporate tax rate has decreased.

2 Which firm should use more debt. Wendy s Inc. or Circuit City Inc.? Wendys: fewer warranties less variable assets Your firm has fewer positive NPV investment opportunities than in previous years Increase Debt The corporate tax rate has decreased. Decrease debt The legislature adopts laws limiting the fees lawyers can collect in bankruptcy proceedings. Increase debt 2

The dividend tax cut becomes permanent. Change in capital structure?

No change Decrease debt (i.e., more equity) Firms will not be subject to taxes, and the personal tax rate on equity = the personal tax rate on debt.

(with bankruptcy costs) All equity Under the assumptions of corporate taxes and no bankruptcy costs, why does the WACC decrease as the

3 The dividend tax cut becomes permanent. Change in capital structure? The personal tax rate on both interest earnings and equity earnings increase by the same percentage rate. Change in capital structure? No change Decrease debt (i.e., more equity) Firms will not be subject to taxes, and the personal tax rate on equity = the personal tax rate on debt. Optimal capital structure? (with bankruptcy costs) All equity Under the assumptions of corporate taxes and no bankruptcy costs, why does the WACC decrease as the firm s debt/equity ratio increases? As $D increases, you are obtaining relatively more of the lower-cost source of funds (debt): i.e., the weight for r D in the WACC formula is increasing, while the weight for r E is decreasing. Note: The cost of equity increases & the cost of debt remains constant as $D increases. 3

Assume T c > 0 and no bankruptcy costs or personal taxes. What happens to the cost of debt (does it increase, decrease or stay the same), as the amount of debt increases?

The cost of debt remains constant (by assumption of no bankruptcy costs) but the cost of equity increases b/c leverage adds variability to net income resulting in greater market risk.

4 Assume T c > 0 and no bankruptcy costs or personal taxes. What happens to the cost of debt (does it increase, decrease or stay the same), as the amount of debt increases? What happens to the cost of equity? Why? The cost of debt remains constant (by assumption of no bankruptcy costs) but the cost of equity increases b/c leverage adds variability to net income resulting in greater market risk. Is it easier to alter the asset or liability side of a firm s balance sheet? Liability side. Exception: Firms in financial distress. Moral: adjust capital structure to conform to assets (& not the reverse). Assume that there is no (personal or corporate) tax advantage to debt vs. equity. Now assume positive bankruptcy costs. Optimal capital structure? All equity The cost of equity.. a) Increases as the amount of debt increases b) Decreases as the amount of debt increases c) In minimized at the optimal capital structure d) Depends on our assumptions about bankruptcy costs and Tc. Answer: a 4

5 With the current applicable corporate and personal marginal tax rates on debt and equity, is there a tax advantage to debt or equity or neither? Debt 1) A firm produces EBIT of $30,000 in perpetuity. Assume that corporate taxes are 30%, and there are no personal taxes. a) What is the value of this firm, if the required rate of return on equity is 10%, and the firm is unlevered? 30,000 (30,000x.3) = 21,000 NI 21,000/0.1 = 210,000 b) What is the value of this same firm if, instead of being an unlevered firm, the firm has $100,000 face-value debt, requiring a 10% coupon rate? V(L) = 210, (100,000) = 240,000 or 30,000 10,000 (Int) 6,000 (Tax) = 14,000 (net income) PV = 10,000/ ,000/.1 = 240,000 c) What is the value of the firm s equity? A = D + E; 240,000 = 100,000 + E; E = 140,000 (or see above) 2) Multiple choice: a) Capital Structure would be irrelevant (You d observe random debt ratios) b) All equity would be optimal c) All debt would be optimal d) Some debt, more than 0% debt, but less than 100% debt would be optimal. i) C Corporate tax rate = 20%; the personal tax rates on debt and equity earnings are both zero, and there are no bankruptcy costs. (1-.8)(1-0) < (1-0); advantage debt ii) A No corporate taxes; No bankruptcy costs; The personal tax rate on debt and equity earnings are both 28%. (1-0)(1-.28) = (1-.28); no advantage iii) B The corporate tax rate is 40%; The personal tax rate on interest income is 58%, and the personal tax rate on equity earnings is 30%. Assume bankruptcy costs are positive when debt > 0%. B (1-.40)(1-.30) = (1-.58); no advantage iv) Assume the corporate tax rate is 20%. The personal tax rate on equity is 10%, and the personal tax rate of debt is 40%. Assume bankruptcy costs are positive when debt > 0%. (1-.20)(1-.10) > (1-.40); advantage equity 3) a) What is the value of an unlevered firm, assuming EBIT = 2,000,000, Tc = 40% and personal taxes on equity (T PE ) = 20%? Assume the cost of equity is 10%. 2,000,000 (.4 x 2,000,000) = 1,200,000 After tax cash flow to equity holders = 1,200,000 (.2 x 1,200,000) = 960,000 PV of 960,000 perpetuity = 960,000 /.1 = 9,600,000 b) Consider the same firm as above (with 2,000,000 in EBIT, and the same corporate and personal taxes), EXCEPT now the firm has $10,000,000 in 5% perpetual debt. Also assume that the personal tax rate on debt (T pd ) is 28%. Compute the value of the levered firm. (Hint: Use the income statement method to value the PV of after-tax cash flows to equity holders and debt-holders in perpetuity.) 2,000, ,000 int 600,000 tax = 900,000 After tax int = 500,000 (500,000 x.28) = 360,000 After tax equity earnings = 900,000 - (900,000 x.2) = 720,000 PV of debt & eq earnings = 360,000/ ,000/.10 = 14,400,000 5

Advanced Corporate Finance. 3. Capital structure

Advanced Corporate Finance. 3. Capital structure Advanced Corporate Finance 3. Capital structure Objectives of the session So far, NPV concept and possibility to move from accounting data to cash flows => But necessity to go further regarding the discount