Corporate Finance

Questions and Practice problems_Chapter 17

Slide 5:
Agency costs of debt: come from the conflict of interest between equity holders and debt
holders. These costs are especially large during financial distress/bankruptcy.
Equity holders are tempted to pursue selfish strategies which may impose agency costs on the
firm; these strategies benefit equity holders at the expense of debt holders.
→ Wealth is transferred from debt holders to equity holders.
Slide 14:
Trade-off theory:
At first (when debt level is low), PV of interest tax shield > PV of financial distress costs → the
firm value increases with debt and the firm should borrow more.
But as the firm has more debt, PV of financial distress costs increase. And at some point, PV of
interest tax shield = PV of financial distress costs, at that point the debt level is optimal. Why?
Because if the firm borrows more than that optimal debt level, PV of interest tax shield < PV of
financial distress costs and the firm value starts to decrease (Note: This is the PV of marginal
benefit and PV of marginal cost of additional debt).
Optimal capital structure (optimal debt level): is when the PV of interest tax shield is exactly
offset by the PV of financial distress costs (Again: this is the marginal benefit and marginal cost
of additional debt). And at that optimal capital structure (optimal debt level), the value of the
firm is maximized, the cost of capital is minimized.
Slide 19:
Pecking order theory: Firms use financing in the following order:
- Internal financing (Retained earnings) (b/c external financing is more costly than internal
financing).
- External financing (debt and equity): Use debt before equity. Why? B/c of asymmetric
information. Issuing equity signals to outside investors that the stock price of the company is
currently overvalued. Outside investors react to that by lowering the stock price.
When debt capacity is exhausted, use equity as the last resort.
The pecking order theory is at odds with the trade-off theory:
• There is no target D/E ratio, whereas the trade-off theory states that firms
pursue the target (optimal) D/E ratio.
• Profitable firms use less debt, whereas the trade-off theory states that profitable
firms use more debt.
• Companies like financial slack, whereas the trade-off theory states that firms
don’t like too much free cash flow because they borrow more debt to reduce
free cash flow (and avoid the agency costs of free cash flow).
(Pecking order theory: Companies like financial slack so that they have less need
for debt (external financing). Trade-off theory: Firms with financial lack (large
free cash flows) may need to use debt to limit the opportunities of managers
pursuing wasteful activities).
Slide 24:
Taxes: Firms in high tax bracket use more debt.
Chapter 17:
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Concept questions (page 553 textbook): 2, 3, 4, 5, 6
2. Stockholder Incentives
Do you agree or disagree with the following statement? A firm’s stockholders will never want
the firm to invest in projects with negative net present values. Why?

False. If the firm is going towards bankruptcy and a certain project will give them a better expected return than
without the project they will vote for the project

 The statement is incorrect. If a firm has debt, it might be advantageous to stockholders for
the firm to undertake risky projects, even those with negative net present values. This
incentive results from the fact that most of the risk of failure is borne by bondholders.
Therefore, value is transferred from the bondholders to the shareholders by undertaking
risky projects, even if the projects have negative NPVs. This incentive is even stronger when
the probability and costs of bankruptcy are high.

3. Capital Structure Decisions

Due to large losses incurred in the past several years, a firm has $2 billion in tax loss
carryforwards. This means that the next $2 billion of the firm’s income will be free from
corporate income taxes. Security analysts estimate that it will take many years for the firm to
generate $2 billion in earnings. The firm has a moderate amount of debt in its capital structure.
The firm’s CEO is deciding whether to issue debt or equity to raise the funds needed to finance
an upcoming project. Which method of financing would you recommend? Why?

The company should issue shares to solve the problem of funding. The tax-loss carry forwards
will let the company's tax rate to zero. Therefore, the company will not benefit from the tax
shied in that debt provided. In addition, the company has a moderate amount of debt, so if
there is an increase in the debt, then the other will allow the company to face financial crisis or
even bankruptcy. If there are bankruptcy costs, the Company shall issue shares in order to fund
this project.

4. Cost of Debt
What steps can stockholders take to reduce the costs of debt?
1) use protective Covenants
Firms can enter into agreements with the bondholders that are designed to decrease the cost
of debt.
There are two types of protective covenants.
- Negative covenants prohibit the company from taking actions that would expose the
bondholders to potential losses.
An example would be prohibiting the payment of dividends in excess of earnings.
- Positive covenants specify an action that the company agrees to take or a condition the
company must abide by.
- Ex. Agreeing to maintain its working capital at a minimum level

2) Repurchase Debt
A firm can eliminate the costs of bankruptcy by eliminating debt from its capital structure.

3) Consolidate Debt
If a firm decreases the number of debt holders, it may be able to decrease the direct costs of
bankruptcy should the firm become insolvent.

5. M&M and Bankruptcy Costs

How does the existence of financial distress costs and agency costs affect Modigliani and
Miller’s theory in a world where corporations pay taxes?

Modigliani and Miller’s theory with corporate taxes indicates that, since there is a positive
tax advantage of debt, the firm should maximize the amount of debt in its capital structure.
In reality, however, no firm adopts an all-debt financing strategy. MM’s theory ignores both
the financial distress and agency costs of debt. The marginal costs of debt continue to
increase with the amount of debt in the firm’s capital structure so that, at some point, the
marginal costs of additional debt will outweigh its marginal tax benefits. Therefore, there is
an optimal level of debt for every firm at the point where the marginal tax benefits of the
debt equal the marginal increase in financial distress and agency costs.

6. Agency Costs of Equity

What are the sources of agency costs of equity?
There are two major sources of the agency costs of equity:

1) Shirking. Managers with small equity holdings tend to reduce their work effort, thereby
hurting both the debt and outside equity holders
2) Perquisites. Since management receives all the benefits of increased perquisites but only
shoulder a fraction of the cost, managers have an incentive to overspend on luxury items at
the expense of debt holders and outside equity holders

Questions and Problems (page 554 textbook): 1, 2, 3, 4

1. Firm Value
Janetta Corp. has an EBIT rate of $975,000 per year that is expected to continue in perpetuity.
The unlevered cost of equity for the company is 14 percent, and the corporate tax rate is 35
percent. The company also has a perpetual bond issue outstanding with a market value of $1.9
million.
a. What is the value of the company?
b. The CFO of the company informs the company president that the value of the company is
$4.8 million. Is the CFO correct?

Tc = 35%
Ru = 14%
EBIT = $975,00
D=debt= $1,900,000

a.
EBIT ×(1−Tc) 975000 ×(1−35 %)
Value of unlevered firm = Vu =  Vu = =
Ru 14 %
$4,526,785.71
Tax shield on debt = Vts= Tc x D = 35% x 1,900,000 = $665,000
Total value of levered firm = VL = Vu + Vts= $4,526,785.71+$665,000 = $ 5,191,785.71

b. The CFO may be correct. The value calculated in part a does not include costs of
debt such as bankruptcy or agency costs.

2. Agency Costs
Tom Scott is the owner, president, and primary salesperson for Scott Manufacturing. Because of
this, the company’s profits are driven by the amount of work Tom does. If he works 40 hours
each week, the company’s EBIT will be $550,000 per year; if he works a 50-hour week, the
company’s EBIT will be $625,000 per year. The company is currently worth $3.2 million. The
company needs a cash infusion of $1.3 million, and it can issue equity or issue debt with an
interest rate of 8 percent. Assume there are no corporate taxes.
a. What are the cash flows to Tom under each scenario?
b. Under which form of financing is Tom likely to work harder?
c. What specific new costs will occur with each form of financing?

a.
- Case 1: When the company issues equity, Tom’s ownership percentage will be diluted.
+ Current Value of company = $3.2 million
+ Cash infusion needed = $1.3 million
+ New Value of company = $3.2 million + $1.3 million = $4.5 million
 New ownership percentage = $3.2 million/$4.5 million = 0.71
 Cash flows to Tom under an equity issue will be 71% of EBIT:
- 40-hour week: CF = 71 % x $550,000 = $390,500
- 50-hour week: CF = 71% x $625,000 = $443,750

- Case 2: When the company issues debt, Tom’s ownership percentage remains the same, but
the company will have to pay interest on the debt.
+ Interest on Debt = 8% x $1.3 million = $104,000
 CF to Tom
- 40-hour week: CF = $550,000 - $104,000= $446,000
- 50-hour week: CF = $625,000 - $104,000= $521,000
b.
Tom is likely to work harder under the debt financing scenario. This is because his cash flows
are higher when he works 50 hours a week compared to the equity financing scenario. The
additional $76,562 ($521,000 - $444,438) in cash flows provides a stronger incentive for Tom to
put in the extra hours.
Tom will work harder under the debt issue since his cash flows will be higher. Tom will gain
more under this form of financing since the payments to bondholders are fixed. Under an
equity issue, new investors share proportionally in his hard work, which will reduce his
propensity for this additional work.

c. Specific New Costs with Each Form of Financing

 Equity Financing:
- Dilution of Ownership: Tom’s ownership percentage decreases, which means he has
less control over the company.
- Potential Dividend Payments: If the company decides to pay dividends, this could be
an additional cost.
Debt Financing:
- Interest Payments: The company must make regular interest payments, which can
strain cash flows.
- Increased Financial Risk: Taking on debt increases the company’s financial risk,
especially if the company faces downturns or cash flow issues.
The direct cost of both issues is the payments made to new investors. The indirect costs
to the debt issue include potential bankruptcy and financial distress costs. The indirect
costs of an equity issue include shirking and perquisites.

3. Nonmarketed Claims
Dream, Inc., has debt outstanding with a face value of $6 million. The value of the firm if it were
entirely financed by equity would be $17.85 million. The company also has 350,000 shares of
stock outstanding that sell at a price of $38 per share. The corporate tax rate is 35 percent.
What is the decrease in the value of the company due to expected bankruptcy costs?

Face Value = D = $6 million

Number of shares = 350,000 shares ; Price per share = $38
Value of the firm if it were entirely financed by equity= Vu= $17.85 million
Tc= 35%

Market value of equity = E = Number of shares x Price per share = 350,000 x $38 = $13,300,000
Total market value of firm = V = E +D= $13,300,000+$6,000,000 = $19,300,000
(VM = B + S)
Tax on Debt = VTS= Tc x D = 35% x $6,000,000 = $2,100,000
(theoretical) Value of levered firm = VL = Vu + VTS= $17.85 + $2.1 = $19.95 million = $19,950,000

The decrease in value due to expected bankruptcy costs

=The decrease in value between value of the levered firm and current market value of the firm
= VL – V = $19.95 - $19.3 = $650,000
With no non-marketed claims, such as bankruptcy costs, we would expect the two values to
be the same. The difference is the value of the non-marketed claims.
VT = VM + VN

$19,950,000 = $19,300,000 + VN

VN = $650,000

4. Capital Structure and Nonmarketed Claims

Suppose the president of the company in the previous problem stated that the company should
increase the amount of debt in its capital structure because of the tax-advantaged status of its
interest payments. His argument is that this action would increase the value of the company.
How would you respond?

 The president may be correct, but he may also be incorrect. It is true that the interest
tax shield is valuable, and adding debt can possibly increase the value of the company.
However,if the company’s debt is increased beyond some level, the value of the
interest tax shield becomes less than the additional costs from financial distress.

The president’s argument is based on the trade-off theory of capital structure, which suggests
that increasing debt can indeed increase the value of the company due to the tax shield
provided by interest payments. However, it’s important to consider several factors before
deciding to increase the amount of debt:

Benefits of Increasing Debt

- Tax Shield: Interest payments on debt are tax-deductible, which reduces the
company’s taxable income and, consequently, its tax liability. This can increase the
firm’s value, as seen in the previous problem where the tax shield added $2.1 million
to the firm’s value.
Drawbacks and Risks
- Bankruptcy Costs: As debt levels increase, so do the risks of financial distress and
bankruptcy. The expected bankruptcy costs can offset the benefits of the tax shield,
as we calculated a $650,000 decrease in value due to expected bankruptcy costs.
- Financial Flexibility: High levels of debt can reduce the company’s financial flexibility.
In times of economic downturn or unexpected expenses, the company might
struggle to meet its debt obligations, leading to financial distress.
- Agency Costs: Increased debt can lead to conflicts between shareholders and debt
holders. Shareholders might prefer riskier projects to maximize their returns, while
debt holders prefer safer projects to ensure they get repaid.
 - Market Perception: Excessive debt can negatively impact the company’s credit rating
and investor perception, potentially leading to higher borrowing costs and lower
stock prices.

Balanced Approach
The company should aim to optimize its capital structure by balancing the tax benefits of
debt with the potential costs of financial distress. This involves:
- Assessing the firm’s risk tolerance: Understanding how much risk the firm can
handle without jeopardizing its financial stability.
- Evaluating market conditions: Considering the current economic environment and
interest rates.
- Maintaining financial flexibility: Ensuring the firm has enough liquidity to manage
unexpected expenses and downturns.
In summary, while increasing debt can provide tax advantages and potentially increase the
firm’s value, it’s crucial to weigh these benefits against the associated risks and costs. A
thoughtful, balanced approach to capital structure is essential for long-term financial health
and stability.