Corporate Finance

Questions and Practice problems_Chapter 17

Chapter 17:
Concept questions (page 553 textbook): 2, 3, 4, 5, 6
Questions and Problems (page 554 textbook): 1, 2, 3, 4
Answers:
Concept questions:
2. The statement is incorrect. If a firm has debt, it might be advantageous to stockholders
for the firm to undertake risky projects, even those with negative net present values. This
incentive results from the fact that most of the risk of failure is borne by bondholders.
Therefore, value is transferred from the bondholders to the shareholders by undertaking
risky projects, even if the projects have negative NPVs. This incentive is even stronger when
the probability and costs of bankruptcy are high.
3. The firm should issue equity in order to finance the project. The tax-loss carry-forwards
make the firm’s effective tax rate zero. Therefore, the company will not benefit from the tax
shield that debt provides. Moreover, since the firm already has a moderate amount of debt in
its capital structure, additional debt will likely increase the probability that the firm will face
financial distress or bankruptcy. As long as there are more bankruptcy costs, the firm should
issue equity in order to finance the project.
4. Stockholders can undertake the following measures in order to minimize the costs of
debt:
 Use protective covenants. Firms can enter into agreements with the bondholders that are
designed to decrease the cost of debt. There are two types of protective covenants.
Negative covenants prohibit the company from taking actions that would expose the
bondholders to potential losses. An example would be prohibiting the payment of
dividends in excess of earnings. Positive covenants specify an action that the company
agrees to take or a condition the company must abide by. An example would be agreeing to
maintain its working capital at a minimum level.
 Repurchase debt. A firm can eliminate the costs of bankruptcy by eliminating debt from its
capital structure.
 Consolidate debt. If a firm decreases the number of debt holders, it may be able to decrease
the direct costs of bankruptcy should the firm become insolvent.
5. Modigliani and Miller’s theory with corporate taxes indicates that, since there is a
positive tax advantage of debt, the firm should maximize the amount of debt in its capital
structure. In reality, however, no firm adopts an all-debt financing strategy. MM’s theory
ignores both the financial distress and agency costs of debt. The marginal costs of debt
continue to increase with the amount of debt in the firm’s capital structure so that, at some
point, the marginal costs of additional debt will outweigh its marginal tax benefits.
Therefore, there is an optimal level of debt for every firm at the point where the marginal tax
benefits of the debt equal the marginal increase in financial distress and agency costs.
6. There are two major sources of the agency costs of equity:
  Shirking. Managers with small equity holdings have a tendency to reduce their work effort,
thereby hurting both the debt holders and outside equity holders.
 Perquisites. Since management receives all the benefits of increased perquisites but only
shoulder a fraction of the cost, managers have an incentive to overspend on luxury items at
the expense of debt holders and outside equity holders.
Questions and Problems:

1.
a. Using M&M Proposition I with taxes, the value of a levered firm is: VL = $5,191,785.71
b. The CFO may be correct. The value calculated in part a does not include costs of debt
such as bankruptcy or agency costs.
2.
a.
Debt issue:
The company needs a cash infusion of $1.3 million. If the company issues debt, the
annual interest payments will be:
Interest = $104,000

The cash flow to the owner will be the EBIT minus the interest payments, or:
40-hour week cash flow = $446,000
50-hour week cash flow = $521,000

Equity issue:
If the company issues equity, the company value will increase by the amount of the issue.
So, the current owner’s equity interest in the company will decrease to:
Tom’s ownership percentage = $3,200,000 / ($3,200,000 + 1,300,000) = .71

So, Tom’s cash flow under an equity issue will be 71 percent of EBIT, or:
40-hour week cash flow = $390,500
50-hour week cash flow = $443,750
b. Tom will work harder under the debt issue since his cash flows will be higher. Tom will
gain more under this form of financing since the payments to bondholders are fixed.
Under an equity issue, new investors share proportionally in his hard work, which will
reduce his propensity for this additional work.
c. The direct cost of both issues is the payments made to new investors. The indirect costs
to the debt issue include potential bankruptcy and financial distress costs. The indirect
costs of an equity issue include shirking and perquisites.

3. According to M&M Proposition I with taxes, the value of the levered firm is:
VT = VL = $19,950,000
We can also calculate the market value of the firm by adding the market value of the debt and
equity. Using this procedure, the total market value of the firm is:
VM = B + S
VM = $19,300,000
With no non-marketed claims, such as bankruptcy costs, we would expect the two values to be
the same. The difference is the value of the non-marketed claims.
VT =VM +VN
$19,950,000 = $19,300,000 + VN
VN = $650,000
4. The president may be correct, but he may also be incorrect. It is true that the interest tax shield
is valuable, and adding debt can possibly increase the value of the company. However, if the
company’s debt is increased beyond some level, the value of the interest tax shield becomes less
than the additional costs from financial distress.