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How Much Should a Firm Borrow?. Student Presentations Why M & M Does Not Hold Corporate Taxes Personal Taxes Financial Distress Pecking Order of Financing Choices. Corporate Taxes. Debt provides a tax shield Interest is tax deductible Government’s share of income declines

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how much should a firm borrow
How Much Should a Firm Borrow?
  • Student Presentations
  • Why M & M Does Not Hold
    • Corporate Taxes
    • Personal Taxes
    • Financial Distress
  • Pecking Order of Financing Choices
corporate taxes
Corporate Taxes
  • Debt provides a tax shield
    • Interest is tax deductible
    • Government’s share of income declines
    • Value of bondholders’ and stockholders’ share increases
present value of tax shield
Present Value of Tax Shield
  • Present value of tax shield
  • If debt is assumed to be a perpetuity
slide5
Compute the present value of the tax shield for a firm in the 35% tax bracket on the following debt issue:

1 year $1,000,000 loan at 8%

A) $25,926

B) $28,000

C) $35,000

D) $350,000

E) None of the above

slide6
Compute the present value of the tax shield for a firm in the 35% tax bracket on the following debt issue:

$1,000,000 perpetuity loan at 8%

A) $28,000

B) $80,000

C) $324,074

D) $350,000

E) None of the above

claims on firm
Claims on Firm
  • Bondholders: Debt
  • Government: Taxes
  • Equityholders: Remainder of firm value
m m and taxes
M&M and Taxes

Value of firm = Value of all-equity-financed firm + PV(tax shield)

what s wrong with pfizer s cfo
What’s Wrong with Pfizer’s CFO?
  • Should also consider personal taxes
  • Cost of financial distress
corporate and personal taxes
Corporate and Personal Taxes

Relative tax advantage of debt vs. equity

If the relative advantage is > 1, debt is preferred

If the relative advantage is < 1, equity is preferred

example advantage to debt
Example – Advantage to Debt

Assume dividends are 40% of earnings

Each dollar of earnings generates $0.40 in dividends and $0.60 in capital gains

Marginal investor is in the 35% tax bracket on interest and 15% on dividends and capital gains

Deferral of capital gains reduces capital gains rate in half (to 7.5%)

slide14

Calculate the relative tax advantage of debt with personal and corporate taxes where: TC = (Corporate tax rate) = 35%; TpE = Personal tax rate on equity income = 30% ; Tp = Personal tax rate on interest income = 20% :

A) 0.76

B) 1.16

C) 1.35

D) 1.76

E) None of the above

slide15

Given the following information, leverage will add how much value to the unlevered firm per dollar of debt? Tc = 34% Tp = 30% TpE=20%

A) $0.66

B) $0.25

C) -$0.66

D) -$0.34

E) None of the above

costs of financial distress
Costs of Financial Distress

Value of firm = Value of all-equity-financed firm

+ PV(tax shield)

– PV(costs of financial distress)

financial distress
Financial Distress

Maximum value of firm

Costs of

financial distress

PV of interest

tax shields

Market Value of The Firm

Value of levered firm

Value of

unlevered

firm

Optimal amount

of debt

Debt

types of financial distress
Types of Financial Distress
  • Bankruptcy costs
    • Direct: legal and court costs
    • Indirect: Inefficient operations, creditors, employees, suppliers, customers
  • Financial distress without bankruptcy
  • Incentives for a firm in difficulty
    • Risk shifting
    • Refusing to contribute equity capital
    • Taking cash from firm
    • Delaying tactics
    • Bait and switch on use of funds from debt
costs of financial distress by asset type
Costs of Financial Distress by Asset Type
  • Tangible assets unaffected by ownership
    • Real estate
    • Airplanes
  • Intangible assets
    • Brand image
    • Technology
    • Human capital
trade off theory of capital structure
Trade-off Theory of Capital Structure
  • Capital structure depends on trade-off between interest tax shield and financial distress
  • High debt firms
    • Safe, tangible assets
    • High taxable income
  • Low debt firms
    • Risky, intangible assets
    • Unprofitable companies
  • Does theory work?
    • Yes and no
pecking order of financing choices
Pecking Order of Financing Choices
  • Firms prefer internal finance
  • Firms adapt payout targets to investment opportunities trying to avoid sudden changes
  • Sticky dividend policies and fluctuations in profitability and investment opportunities lead to cash flow shifts
  • If external finance is required, firms issue debt first, then equity
tests of pecking order
Tests of Pecking Order
  • Large firms tend to have higher debt ratios
  • Firms with high ratios of fixed assets to total assets have higher debt ratios
  • More profitable firms have lower debt ratios
  • Firms with higher ratios of book-to-market values have lower debt ratios
next class
Next Class
  • Thursday, April 12
    • Financing and Valuation – Chapter 19
    • Problem Set 3