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SMChap018 - Chapter 18 How Much Should a Corporation Borrow...

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Chapter 18 - How Much Should a Corporation Borrow? CHAPTER 18 How Much Should a Corporation Borrow? Answers to Problem Sets 1. 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. Est. Time: 01 – 05 2. a. PV tax shield = tax rate x debt = T c D = 0.40 x $40 = $16. b. The tax advantage can be found by multiplying the amount borrowed by the tax rate: T c x 20 = $8. Est. Time: 01 – 05 3. Relative advantage of debt = c pE p T T T 1 1 1 =  00 . 1 65 . 1 65 . . If the company decides to pay out all equity income as cash dividends that are taxed at 15% the relative advantage becomes: =  18 . 1 65 . 85 . 65 . Est. Time: 01 – 05 4. 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 incentive to borrow. Est. Time: 01 – 05 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 to costs. 18-1
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Chapter 18 - How Much Should a Corporation Borrow? 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. Est. Time: 01 – 05 6. Not necessarily. Announcement of bankruptcy can send a message of poor profits and prospects. Part of the share price drop can be attributed to anticipated bankruptcy costs, however. Est. Time: 01 – 05 7. More profitable firms have more taxable income to shield and are less likely to incur the costs of distress. Therefore the trade-off theory predicts high (book) debt ratios. In practice the more profitable companies borrow the least. Est. Time: 01 – 05 8. The four variables are size, tangible assets, profitability, and market-to-book ratios. Debt ratios tend to be higher for larger firms and those with more tangible assets. Conversely, more profitable firms and firms with higher market-to-book values have lower debt ratios. Est. Time: 01 – 05 9. When a company issues 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 can 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.
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