{[ promptMessage ]}

Bookmark it

{[ promptMessage ]}

Ch15_5th - Solutions to Chapter 15 Debt Policy 1 a.True b...

Info icon This preview shows pages 1–3. Sign up to view the full content.

View Full Document Right Arrow Icon
Solutions to Chapter 15 Debt Policy 1. a.True. b. False. As financial leverage increases, the expected rate of return on equity rises by just enough to compensate for its higher risk. The value of the firm and stockholders’ wealth are unaffected. c.False. The sensitivity of equity returns to business risk, and therefore the cost of equity, increases with leverage even without a change in the risk of financial distress. d. True. 2. While the cost of debt and the cost of equity both increase, the weight applied to debt in the cost of capital formula also increases. Applying a higher weight to the lower- cost source of capital offsets the increase in the cost of debt and the cost of equity. 3. The interest tax shield is the reduction in corporate income taxes due to the fact that interest is treated as an expense that reduces taxable income. To the extent that the government collects less tax, there is a bigger pie of after-tax income available to the debt and equity holders. Example: Assume operating income is $100,000, the interest rate on debt is 10%, and the tax rate is 35%. Compare income for an unlevered firm versus a firm that borrows $400,000: Zero-debt firm $400,000 of debt Operating income $100,000 $100,000 Interest on debt 0 40,000 Before-tax income 100,000 60,000 Tax at 35% 35,000 21,000 After-tax income 65,000 39,000 Sum of debt interest plus after-tax income $ 65,000 $ 79,000 The combined debt interest plus equity income is higher for the levered firm. The difference equals $14,000, which is also the difference in taxes paid by the two firms. 4. PV(Tax shield) = million 280 $ 800 $ 35 . 0 076 . 0 ) 800 $ 076 . 0 ( 35 . 0 = × = × × 15-1
Image of page 1

Info icon This preview has intentionally blurred sections. Sign up to view the full version.

View Full Document Right Arrow Icon
5. The tradeoff theory of capital structure holds that the optimal debt ratio is determined by striking a balance between the advantages and disadvantages of debt financing. The advantage of debt financing is the interest tax shield. The disadvantages are the various costs of financial distress. As leverage increases, the marginal tax shield from each dollar of additional borrowing falls. This is a consequence of the increasing probability that, with higher interest expense, the firm will not have positive taxable income and therefore will not pay taxes. At the same time, the expected costs of financial distress increase with leverage. As leverage increases, the marginal cost of financial distress eventually outweighs the interest tax shield. At the optimal debt ratio, the increase in the present value of tax savings from additional borrowing is exactly offset by increases in the present value of the costs of financial distress. 6. Direct costs of bankruptcy such as legal or administrative costs. Indirect costs due to the problems encountered when managing a firm in bankruptcy proceedings (e.g., interference by creditors or difficulties buying supplies on credit). Poor investment decisions resulting from conflicts of interest between creditors and stockholders.
Image of page 2
Image of page 3
This is the end of the preview. Sign up to access the rest of the document.

{[ snackBarMessage ]}

What students are saying

  • Left Quote Icon

    As a current student on this bumpy collegiate pathway, I stumbled upon Course Hero, where I can find study resources for nearly all my courses, get online help from tutors 24/7, and even share my old projects, papers, and lecture notes with other students.

    Student Picture

    Kiran Temple University Fox School of Business ‘17, Course Hero Intern

  • Left Quote Icon

    I cannot even describe how much Course Hero helped me this summer. It’s truly become something I can always rely on and help me. In the end, I was not only able to survive summer classes, but I was able to thrive thanks to Course Hero.

    Student Picture

    Dana University of Pennsylvania ‘17, Course Hero Intern

  • Left Quote Icon

    The ability to access any university’s resources through Course Hero proved invaluable in my case. I was behind on Tulane coursework and actually used UCLA’s materials to help me move forward and get everything together on time.

    Student Picture

    Jill Tulane University ‘16, Course Hero Intern