Chapter 14 - R. 1. R. 2. R. 3. R. 4. R. 5. R. 6. R. 7....

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Unformatted text preview: R. 1. R. 2. R. 3. R. 4. R. 5. R. 6. R. 7. CHAPTER 14 REVIEW QUESTIONS Corporations in the United States are required to pay taxes established in the corporate tax code. Although the shareholders are the legal owners of the corporation’s assets, federal, state, and local governments also have a claim to those assets. At the time of this writing, the top federal corporate tax rate of 35 percent establishes that the federal government has up to a 35 percent claim to the firm’s assets. Corporate taxes are levied on the difference between revenues and expenses. High revenues do not however guarantee that taxes owed will be high. Expenses, sometimes called deductions, act to lower the amount of taxable income. Modigliani and Miller demonstrated that when corporate taxes are introduced, interest on the debt serves as a deduction and reduces the amount of corporate tax owed. Because of this tax advantage to the use of debt financing, the optimal capital structure is to use as much debt as possible — — even up to 100 percent or all debt. In the Miller tax model the tax advantage to debt at the corporate level is offset by the tax disadvantage to debt at the individual income tax level. Because the advantages and disadvantages cancel each other out, the capital structure decision is irrelevant to firm value and shareholder wealth. The traditional view of bankruptcy states that bankruptcy most often occurs when the cash flows from the firm’s assets are insufficient to cover Cash expenses including the cash flows owed to the firm’s debtholders. Because bankruptcy is often considered bad, and since the use of debt can increase the probability of bankruptcy, traditionalists view using too much debt as bad. The modern View of bankruptcy recognizes that bankruptcy is a legal event that by itself does not destroy or create value. In fact, given the shareholder’s limited liability, bankruptcy can be used to walk away from contracts that require them to make payments such as coupon interest payments on debt. Ignoring legal costs and in well functioning markets, modernist do not perceive increased chances of bankruptcy as a reason to restrain the use of debt. Equity value reflects the financial health of the firm. In times of financial distress, we would expect the equity to trade at low levels reflecting the low probability of earning a positive residual cash flow. Consider a firm in financial distress such that their equity is trading at near zero. The announcement of bankruptcy might allow the firm to use impending bankruptcy to negotiate improved contracts with its creditors —— debtholders, workers, governments —— — such that declaring bankruptcy can increase the residual cash flow. 104 R. 8. R. 9. Equity can be viewed as a call option on the firm’s assets. If the assets of a corporation have value greater than the face value of the corporation’s debt, the equityholders will exercise their option, payoff the debtholders, and claim the residual cash flow. If the assets have insufficient value when a major debt payment is due, the equityholders can simply allow their option to expire, in other words, to declare bankruptcy. Agency costs, introduced in Chapter 2, are the costs associated when hiring another person to perform a certain task. The person hired is called the agent, and the person hiring the other person is called the principal. In the case of corporate finance, the principal is usually the shareholder and the agent is the firm’s management, and agency costs are introduced if the manager’s objectives are not aligned with the objectives of the shareholders. But, in capital structure analysis, debtholders enter as a third party who have the objective of maximizing the probability that they will be paid. 105 CHAPTER 14 PROBLEMS 1. $594,000 can be solved using format of table below: Marley, Inc. Operating Cash Flow $900,000 Interest Expense $0 Profit Before Taxes $900,000 Taxes at 34.00% $306,000 Cash Flow After Taxes $594,000 2. All figures shown in Table below: Moon Lighting Company Operating Cash Flow $725,000 Interest Expense $0 Profit Before Taxes $725,000 Taxes at 34.00% $246,500 Income After Taxes $478,500 Equity Earn per Share $0.24 3. a. $144,500 taxes are $102,000 lower due to interest tax shield (34% * $300,000) b. $280,500 and $0.28 per share Moon Lighting Company Operating Cash Flow $725,000 Interest Expense $300,000 Found as 15% of $2,000,000 Profit Before Taxes $425,000 Taxes at 34.00% $144,500 Income After Taxes $280,500 Equity Earn per Share $0.28 4. Unlevered $01886; Levered $02112 Magnum Headache Unlevered Levered Operating Cash Flow $1,000,000 $1,000,000 Interest Expense $0 $200,000 Profit Before Taxes $1,000,000 $800,000 Taxes at 34.00% $340,000 $272,000 Income After Taxes $660,000 $528,000 Equity Earn per Share $01886 $02112 5. Levered Value = $7,680,000 Levered Value = Unlevered Value + (Tax Rate * Debt) Levered Value = $7,000,000 + (0.34 * $2,000,000) Levered Value = $7,680,000 106 6. a. $81,600 as shown below implicitly in difference b. $5,680,000 as shown below Boomer’s Boards Unlevered Levered Operating Cash Flow $1,000,000 $1,000,000 Interest Expense $0 $240,000 Profit Before Taxes $1,000,000 $760,000 Taxes at 34.00% $340,000 $258,400 Income After Taxes $660,000 $501,600 Levered Value = Unlevered Value + (Tax Rate * Debt) Levered Value = $5,000,000 + (0.34 * $2,000,000) Levered Value = $5,680,000 7. $3,400,000 found as the tax rate times the permanent debt amount Levered Value = Unlevered Value + (Tax Rate * Debt) $30,000,000 = Unlevered Value + (0.34 * $10,000,000) Unlevered Value = $30,000,000 — $3,400,000 = $26,600,000 8. $42,000 Tax Rate * Debt = 0.40 * $700,000 = $280,000 New tax shield Tax Rate * Debt = 0.34 * $700,000 = $238,000 Old tax shield 9. Operating Income Cash Flow Earnings Cash Flow Taxes After Taxes Per Share Recession $4,000 $1,360 $2,640 $0.26 Normal $8,000 $2,720 $5,280 $0.53 Boom $14,000 $4,760 $9,240 $0.92 10. Operating Interest Taxable Income Net Earnings Cash Flow Expense Income Taxes Income Per Share Recession $4,000 $3,000 $1,000 $340 $660 $0.09 Normal $8,000 $3,000 $5,000 $1,700 $3,300 $0.44 Boom $14,000 $3,000 $11,000 $3,740 $7,260 $0.97 11. $12,000 is the break even total cash flow Levered Unlevered (CF — Int Exp)*(1—tax) / # Shares = (Total CF)*(1—tax) / # Shares (CF — $3,000)(.66) / 7,500 = (CF*.66) / 10,000 (CF -— $3,000)(.66)(1.33333) = (CF*.66) 0.88*CF — $2,640 = 0.66*CF 0.22*CF = $2,640 CF = $12,000 107 12a. First, compute the profitability of owning 5% of Peg: Peg Operating Cash Flow $500.00 Interest Expense $200.00 Profit Before Taxes $300.00 Income Tax 34.00% $102.00 Income after Taxes $198.00 CF to 5% Equity $9.90 b. Second, find the profitability of owning 5% of Square Square Operating Cash Flow $500.00 Interest Expense $0.00 Profit Before Taxes $500.00 Income Tax 34.00% $170.00 Income after Taxes $330.00 CF to 5% Equity $16.50 Finally, compute the cash flow to using homemade leverage: OK CF to 5% of the Equity of Square $16.50 Less Interest Expense $10.00 CF to Homemade Leverage: $6.50 Since homemade leverage calls for the use of debt in an amount equal to 5% of the debt of Peg’s and since Peg has $200 per year in interest, we know that the use of the homemade leverage strategy causes 5% of the interest, or $10.00. c. The proof is that the alternatives produce different bottom lines. The reason is that the use of homemade leverage does not produce the interest tax shield that is received in the case of the use of corporate leverage. 13.First, compute the profitability of each firm for each state using 34% taxes: Giants, Inc. Bad OK Good Operating Cash Flow $50,000 $100,000 $150,000 Interest Expense $50,000 $50,000 $50,000 Profit Before Taxes $0 $50,000 $100,000 Inc Taxes 34.00% $0 $17,000 $34,000 Net Income $0 $33,000 $66,000 CF to 10% Equity $0 $3,300 $6,600 108 Jets, Inc. Bad OK Good Operating Cash Flow $50,000 $100,000 $150,000 Interest Expense $0 $0 $0 Profit Before Taxes $50,000 $100,000 $150,000 Inc Taxes 34.00% $17,000 $34,000 $51,000 Net Income $33,000 $66,000 $99,000 CF to 10% Equity $3,300 $6,600 $9,900 Next, compute the cash flow to each investment alternative: 14. 15. a. a. b. C. First Alternative: Buy 10% of Giants, Inc. Result is found directly from above Giants, Inc. Table Bad $0 OK $3,300 Good CF to 10% Equity $6,600 Second Alternative: Buy 10% of Jets, Inc. and borrow 10% as much as Giants Result is found from above Jets Table and by subtracting $5,000 interest expense: Bad OK Good CF to 10% Equity $3,300 $6,600 $9,900 Less Interest Expense $5,000 $5,000 $5,000 CF to Homemade Lev.: ($1,700) $1,600 $4,900 The proof is that the alternatives produce different bottom lines. The reason is that the use of homemade leverage does not produce the interest tax shield that is received in the case of the use of corporate leverage. $306.00 $1,000,000 * 9% = Total Interest = $90,000 $90,000 * 1% = Elizabeth’s Interest = $900 $900 * 34% = Elizabeth’s Tax Liability = $306.00 $10,340,000 b.$10,000,000 c.$10,100,000 Levered Value = Unlevered Value + ((1—((1—Tc)(1—Te)/(1—Td))) * Debt) Levered Value = $10,000,000 + ((1—((1—Tc)(1—Te)/(1—Td))) * $1,000,000) Levered Value = $10,000,000 + ((1—((0.66)*(0.66)/(0.66)))) * $1,000,000) Levered Value = $10,340,000 Levered Value = $10,000,000 + ((1—((0.66)*(1.0)/(0.66))) * $1,000,000) Levered Value = $10,000,000 Levered Value = $10,000,000 + ((1~((0.66)*(0.90)/(0.66))) * $1,000,000) Levered Value = $10,100,000 16. $0.34 Added Value = (1—((0.66)*(0.66)/(0.66))) * $1 = $0.34 109 17. $0.00 Added Value = (1—((0.66)*(1.0)/(0.66))) * $1 = $0.00 18. $0.15 Added Value = (1—((0.66)*(0.85)/(0.66))) * $1 = $0.15 19. First, recall the profitability of each firm for each state using 34% taxes: Giants, Inc. Bad OK Good Operating Cash Flow $50,000 $100,000 $150,000 Interest Expense $50,000 $50,000 $50,000 Profit Before Taxes $0 $50,000 $100,000 Inc Taxes 34.00% $0 $17,000 $34,000 Net Income $0 $33,000 $66,000 CF to 10% Equity $0 $3,300 $6,600 Jets, Inc. Bad OK Good Operating Cash Flow $50,000 $100,000 $150,000 Interest Expense $0 $0 $0 Profit Before Taxes $50,000 $100,000 $150,000 Inc Taxes 34.00% $17,000 $34,000 $51,000 Net Income $33,000 $66,000 $99,000 CF to 10% Equity $3,300 $6,600 $9,900 Next, compute the cash flow to each investment alternative: First Alternative: Buy 10% of Giants, Inc. With personal taxes, the result is still found directly from above Giants, Inc. Table since the investment is equity and the personal tax rate on equity income is zero: Bad OK Good CF to 10% Equity $0 $3,300 $6,600 Second Alternative: Buy 10% of Jets, Inc. and borrow 10% as much as Giants Result is found from above Jets Table and by subtracting $5,000 interest expense However, since the personal tax rate on debt income is 34%, we can add in the tax savings from being able to reduce taxable income due to personal tax shield. Bad OK Good CF to 10% Equity $3,300 $6,600 $9,900 Less Interest Expense ($5,000) ($5,000) ($5,000) Plus Personal Inc Tax $1,700 $1,700 $1,700 CF to Homemade Lev.: $0 $3,300 $6,600 The proof is that the alternatives produce the same bottom lines. 110 CHAPTER 14 DISCUSSION QUESTIONS 1. When a firm is at the point or is approaching the point where the face value of its liabilities exceeds its assets, bankruptcy prevents the equity of the firm from being driven to negative values. In other words, bankruptcy is what financial managers of a firm use in order to protect shareholders from various types of creditors. In that sense, bankruptcy is clearly the "friend" to an equity holder. The confusion arises because the circumstances that drive a financial manager to seek bankruptcy are very unpleasant -— —— usually the firm has suffered massive losses. It is often easy to associate bankruptcy as being the cause of the problem rather than the solution. 2. The interest income paid to debt holders from a corporation is tax deductible to the corporation in computing the corporate income tax liability. However, the returns (dividends) paid to equity holders are not tax deductible to the corporation. Hence, many people argue that debt has an income tax advantage since equity is double taxed —— — once at the corporate income tax level and once at the personal income tax level. Others argue that this favorable treatment of interest expense at the corporate tax level is partially or fully offset by tax advantages to equity income at the personal income tax level. This debate has not been settled. Nevertheless, in order to reduce or eliminate the corporate tax advantage to debt the government could either make dividend payments tax deductible to the firm or could remove the tax deductibility of interest payments. At least partial forms of the latter have been proposed. 3. Corporations place numerous restrictions on themselves or "covenants" into the debt contract that protect the bond holders and increase the probability that they will be paid. The corporations include these covenants in order to reduce the cost of the debt. Prospective bond holders can not "demand" such restrictions since they can can not force a corporation to do anything until they become actual bond holders. Prospective bond holders can simply offer lower prices or refuse to purchase debt that does not contain the covenants that they desire. Once the debt holders have purchased the bonds, they can attempt to protect themselves by making sure that the firm adheres to the covenants. 4. a. The firm’s financial managers realize that the firm will likely go bankrupt unless something extremely wonderful happens. Since the firm has little or no value to its shareholders if nothing unusual is done, there may be an incentive to take a very large risk. If the risk produces a huge loss, the firm will go bankrupt and the equity holders will receive nothing. Note that this is what probably would have happened anyway. However, is the firm "strikes it rich", the equity holders will receive enormous benefits. This strategy would not work if shareholders were financially 111 responsible for all losses. In such a case, there would be no incentive to take bad risks. However, the limited liability protection afforded to shareholders by the ability to declare bankruptcy can lessen the downside risks to the shareholders and give them the reason to take risks, even if they must take bad risks (negative NPV). b. Yes, a very low risk but slightly positive—NPV project would be rejected by the shareholders under some circumstances since it might still be unable to prevent the firm from going bankrupt and therefore the advantages to the project would lessen the loss to the bond holders rather than help the stockholders. A counter argument would be that the stockholders would purchase the bonds and then accept the project so that they could reap the benefits of the positive NPV. c. There are market forces that can act to reduce the probability that a firm will use the advantages of limited liability to transfer wealth from bond holders to its shareholders. A firm that operates near the edge of bankruptcy may have problems attracting customers, employees and so forth since many people would be reluctant to take the risk that the firm would go bankrupt and be unable to fulfill its committments such as warranties. . Under most circumstances, in a competitive market we would expect the NPV of a financing decision to be zero since the prices of securities reflect their values. But, if there is inside information, information available to financial managers but not available in the marketplace, then we can expect that the market value could deviate from the value based upon all information. In the case of Lucky, Inc. it would be a mistake to issue equity at current market prices since the financial managers know that the equity is worth more based upon their inside information. The firm should consider alternative financing such as short term credit. This question should raise serious concerns about what financial managers are implicitly revealing when they do decide to issue equity. In many ways, the decision to issue equity can be viewed as an information signal from financial managers (people with inside information) that the firm is not undervalued and perhaps is overvalued. 112 ...
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This note was uploaded on 11/30/2011 for the course FINOPMGT 301 taught by Professor Lacey during the Spring '10 term at UMass (Amherst).

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Chapter 14 - R. 1. R. 2. R. 3. R. 4. R. 5. R. 6. R. 7....

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