Chapter 14 - How Much Should a Corporation Borrow?

CHAPTER 14
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.

2. a. PV tax shield = TcD = $16.

b. Tc X 20 = $8.

3.
1 − Tp
Relative advantage of debt =
(1 − T )(1 − T )
pE c

.65
= 1.00
(1)(.65)
=

.65
= 1.18
Relative advantage
(.85)(.65)
=

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.

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.

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
14-3.

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Chapter 14 - How Much Should a Corporation Borrow?

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.

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 least.

8. Debt ratios tend to be higher for larger firms with more tangible assets. Debt
ratios tend to be lower for more profitable firms with higher market-to-book ratios.

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.

10. a. The cumulative requirement for external financing.

b. More profitable firms can rely more on internal cash flow and need less
external financing.

11. Financial slack is most valuable to growth companies with good but uncertain
investment opportunities. Slack means that financing can be raised quickly for
positive-NPV investments. But too much financial slack can tempt -mature
companies to overinvest. Increased borrowing can force such firms to pay out
cash to investors.

TC (rDD) 0.35(0.08  $1,000)

12. a. PV(tax shield) = = = $25.93
1 + rD 1.08

5
0.35(0.08  $1,000)
b. PV(tax shield) =  = $111.80
t =1 (1.08) t

c. PV(tax shield) = TC D = $350

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Chapter 14 - How Much Should a Corporation Borrow?

13. For $1 of debt income:

Corporate tax = $0
Personal tax = 0.35  $1 = $0.350
Total = $0.350
For $1 of equity income, with all capital gains realized immediately:
Corporate tax = 0.35  $1 = $0.350
Personal tax = 0.35  0.5  [$1 – (0.35$1)] + 0.15  0.5  [$1 – (0.35$1)] =
$0.163
Total = $0.513
For $1 of equity income, with all capital gains deferred forever:
Corporate tax = 0.35  $1 = $0.350
Personal tax = 0.35  0.5  [$1 – (0.35$1)] = $0.114
Total = $0.464

14. Consider a firm that is levered, has perpetual expected cash flow X, and has an
interest rate for debt of rD. The personal and corporate tax rates are Tp and Tc,
respectively. The cash flow to stockholders each year is:
(X - rDD)(1 - Tc)(1 - Tp)
Therefore, the value of the stockholders’ position is:

(X) (1 − Tc ) (1 − Tp ) (rD ) ( D) (1 − Tc ) (1 − Tp )
VL = −
(r) (1 − Tp ) (rD ) (1 − Tp )

(X) (1 − Tc ) (1 − Tp )
VL = − [( D) (1 − Tc )]
(r) (1 − Tp )

where r is the opportunity cost of capital for an all-equity-financed firm. If the

stockholders borrow D at the same rate rD, and invest in the unlevered firm, their
cash flow each year is:
[(X) (1 − Tc ) (1 − Tp )] − [ ( rD ) ( D) (1 − Tp )]

The value of the stockholders’ position is then:

(X) (1 − Tc ) (1 − Tp ) (rD ) ( D) (1 − Tp )
VU = −
(r) (1 − Tp ) (rD ) (1 − Tp )

(X) (1 − Tc ) (1 − Tp )
VU = −D
(r) (1 − Tp )

The difference in stockholder wealth, for investment in the same assets, is:

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Chapter 14 - How Much Should a Corporation Borrow?

VL – VU = DTc
This is the change in stockholder wealth predicted by MM.
If individuals could not deduct interest for personal tax purposes, then:
(X)(1 − Tc ) (1 − Tp ) (rD )( D)
VU = −
(r) (1 − Tp ) (rD ) (1 − Tp )
Then:
(rD ) ( D) − [ ( rD )( D)(1 − Tc ) (1 − Tp )]
VL − VU =
(rD ) (1 − Tp )

 Tp 
VL − VU = ( D Tc ) +  D 
 (1 − T ) 
 p 
So the value of the shareholders’ position in the levered firm is relatively greater
when no personal interest deduction is allowed.

15. Long-term debt increases by: $10,000 − $4,943 = $5,057 million

The corporate tax rate is 35%, so firm value increases by:
0.35  $3,874 = $1,770 million
The market value of the firm is now: $79,397 + $1,770 = $81,167 million
The market value balance sheet is:
Net working capital $4986 $10,000 Long-term debt
PV interest tax shield 3500 10,175 Other long-term liabilities
Long-term assets 72,681 60,992 Equity
Total Assets $81,167 $81,167 Total value

16. Assume the following facts for Circular File:

Book Values
Net working capital $20 $50 Bonds outstanding
Fixed assets 80 50 Common stock
Total assets $100 $100 Total value
Market Values
Net working capital $20 $25 Bonds outstanding
Fixed assets 10 5 Common stock
Total assets $30 $30 Total value

a. Playing for Time

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Chapter 14 - How Much Should a Corporation Borrow?

Suppose Circular File foregoes replacement of $10 of capital equipment,

so that the new balance sheet may appear as follows:
Market Values
Net working capital $30 $29 Bonds outstanding
Fixed assets 8 9 Common stock
Total assets $38 $38 Total value
Here the shareholder is better off but has obviously diminished the firm’s
competitive ability.

b. Cash In and Run

Suppose the firm pays a $5 dividend:
Market Values
Net working capital $15 $23 Bonds outstanding
Fixed assets 10 2 Common stock
Total assets $25 $25 Total value
Here the value of common stock should have fallen to zero, but the
bondholders bear part of the burden.

c. Bait and Switch

Market Values
Net working capital $30 $20 New Bonds outstanding
20 Old Bonds outstanding
Fixed assets 20 10 Common stock
Total assets $50 $50 Total value

17. Answers here will vary according to the companies chosen; however, the
important considerations are given in the text, Section 19.3.

18. a. Stockholders win. Bond value falls since the value of assets securing
the bond has fallen.

b. Bondholder wins if we assume the cash is left invested in Treasury bills.

The bondholder is sure to get $26 plus interest. Stock value is zero
because there is no chance that the firm value can rise above $50.

c. The bondholders lose. The firm adds assets worth $10 and debt
worth $10. This would increase Circular’s debt ratio, leaving the old
bondholders more exposed. The old bondholders’ loss is the
stockholders’ gain.

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Chapter 14 - How Much Should a Corporation Borrow?

d. Both bondholders and stockholders win. They share the (net) increase
in firm value. The bondholders’ position is not eroded by the issue of a
junior security. (We assume that the preferred does not lead to still
more game playing and that the new investment does not make the
firm’s assets safer or riskier.)

e. Bondholders lose because they are at risk for a longer time.

Stockholders win.

19. a. SOS stockholders could lose if they invest in the positive NPV project and
then SOS becomes bankrupt. Under these conditions, the benefits of the
project accrue to the bondholders.

b. If the new project is sufficiently risky, then, even though it has a negative
NPV, it might increase stockholder wealth by more than the money
invested. This is a result of the fact that, for a very risky investment,
undertaken by a firm with a significant risk of default, stockholders benefit
if a more favorable outcome is actually realized, while the cost of
unfavorable outcomes is borne by bondholders.

c. Again, think of the extreme case: Suppose SOS pays out all of its assets
as one lump-sum dividend. Stockholders get all of the assets, and the
bondholders are left with nothing. (Note: fraudulent conveyance laws may
prevent this outcome)

20. a. The bondholders may benefit. The fine print limits actions that transfer
wealth from the bondholders to the stockholders.

b. The stockholders may benefit. In the absence of fine print, bondholders

charge a higher rate of interest to ensure that they receive a fair deal. The
firm would probably issue the bond with standard restrictions. It is likely
that the restrictions would be less costly than the higher interest rate.

21. Other things equal, the announcement of a new stock issue to fund an
investment project with an NPV of $40 million should increase equity value by
$40 million (less issue costs). But, based on past evidence, management
expects equity value to fall by $30 million. There may be several reasons for
the discrepancy:
(i) Investors may have already discounted the proposed investment. (However,
this alone would not explain a fall in equity value.)
(ii) Investors may not be aware of the project at all, but they may believe instead
that cash is required because of, say, low levels of operating cash flow.

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Chapter 14 - How Much Should a Corporation Borrow?

(iii) Investors may believe that the firm’s decision to issue equity rather than debt
signals management’s belief that the stock is overvalued.
If the stock is indeed overvalued, the stock issue merely brings forward a stock
price decline that will occur eventually anyway. Therefore, the fall in value is not
an issue cost in the same sense as the underwriter’s spread. If the stock is not
overvalued, management needs to consider whether it could release some
information to convince investors that its stock is correctly valued, or whether it
could finance the project by an issue of debt.

22. a. Masulis’ results are consistent with the view that debt is always preferable
because of its tax advantage, but are not consistent with the ‘tradeoff’
theory, which holds that management strikes a balance between the tax
advantage of debt and the costs of possible financial distress. In the
tradeoff theory, exchange offers would be undertaken to move the firm’s
debt level toward the optimum. That ought to be good news, if anything,
regardless of whether leverage is increased or decreased.

b. The results are consistent with the evidence regarding the announcement
effects on security issues and repurchases.

c. One explanation is that the exchange offers signal management’s

assessment of the firm’s prospects. Management would only be willing to
take on more debt if they were quite confident about future cash flow, for
example, and would want to decrease debt if they were concerned about
the firm’s ability to meet debt payments in the future.

23. a.
Expected Payoff to Bank Expected Payoff to Ms. Ketchup
Project 1 +10.0 +5
Project 2 (0.410) + (0.60) = +4.0 (0.414) + (0.60)=+5.6
Ms. Ketchup would undertake Project 2.

b. Break even will occur when Ms. Ketchup’s expected payoff from Project 2
is equal to her expected payoff from Project 1. If X is Ms. Ketchup’s
payment on the loan, then her payoff from Project 2 is:
0.4 (24 – X)
Setting this expression equal to 5 (Ms. Ketchup’s payoff from Project 1),
and solving, we find that: X = 11.5
Therefore, Ms. Ketchup will borrow less than the present value of this
payment.

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Chapter 14 - How Much Should a Corporation Borrow?

24. One advantage of setting debt-equity targets based on bond ratings is that firms
may minimize borrowing costs. This is especially true of bond covenants
establish lower ratings as a condition of default. One disadvantage is that firms
may not take full advantage of tax benefits from debt financing if they refuse to
borrow amounts they could finance with relative safety.

25. The right measure in principle is the ratio derived from market-value balance
sheets. Book balance sheets represent historical values for debt and equity
which can be significantly different from market values. Any changes in capital
structure are made at current market values.
The trade-off theory proposes to explain market leverage. Increases or
decreases in debt levels take place at market values. For example, a decision to
reduce the likelihood of financial distress by retirement of debt means that
existing debt is acquired at market value, and that the resulting decrease in
interest tax shields is based on the market value of the retired debt. Similarly, a
decision to increase interest tax shields by increasing debt requires that new debt
be issued at current market prices.
Similarly, the pecking-order theory is based on market values of debt and equity.
Internal financing from reinvested earnings is equity financing based on current
market values; the alternative to increased internal financing is a distribution of
earnings to shareholders. Debt capacity is measured by the current market
value of debt because the financial markets view the amount of existing debt as
the payment required to pay off that debt.

26. If it was always possible to issue stock quickly and use the additional proceeds to
repurchase debt, then firms may indeed avoid financial distress. But potential
equity investors may be reluctant to buy stock in a firm if adverse market events
are likely to place the bonds in default: they would effectively be putting money
into a sinking ship, and those proceeds would go to repay the senior bond claims
in bankruptcy. This is especially true if the bonds quickly move into default (or if
there are cross-default provisions where one bond series default triggers other
defaults).

In some cases, bondholders may recognize that the firm has greater value as a
going concern and agree to take a haircut on interest payments in exchange for
an equity infusion. Under these circumstances, a firm may indeed be able to
raise additional equity—but the negotiations and gamesmanship of these
workout situations can get tricky.

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