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

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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

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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.
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