Transcript Introduction a basic terms II

JEM034 Corporate Finance
(tutorial 4)
Matěj Kuc
Petr Polák
Karolína Růžičková
Diana Žigraiová
March 10, 2015
Exercise 1

Markum Enterprises is considering
permanently adding $100million of debt to
its capital structure. Markum’s corporate
tax rate is 35% (Berk and DeMarzo).
 Absent personal taxes, what is the value of the
interest tax shield from the new debt?
 If investors pay a tax rate of 40% on interest
income, and a tax rate of 20% on income from
dividends and capital gains, what is the value of
the interest tax shield from the new debt?
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Exercise 2 (1/2)
Overnight Publishing Company (OPC) has $2 mil. in excess cash. The
firm plans to use this cash either to retire all of its outstanding debt
or to purchase equity. The firm’s debt is held by one institution that
is willing to sell it back to OPC for $2 mil. The institution will not
charge OPC any transaction costs. Once OPC becomes an all-equity
firm, it will remain unlevered forever. If OPC does not retire the debt,
the company will use $2 mil. in cash to buy back some of its stocks on
the open market. Also repurchasing the stock has no transaction
costs. The company will generate $1.1 mil. of annual earnings before
interest and taxes in perpetuity regardless of its capital structure.
The firm immediately pays out all earnings as dividends at the end of
each year. OPC is subject to corporate tax of 35%, and the required
rate of return on firm’s unlevered equity is 20%. The personal tax
rate on interest income is 25% and the personal tax rate on equity
distributions is 10%. Ignore bankruptcy costs.
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Exercise 2 (2/2)

What is the value of OPC if it chooses to retire all of its debt and
become an unlevered firm?

What is the value of OPC if decides to purchase stock instead of
retire debt?
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What are direct and indirect costs of
bankruptcy?

Direct costs
 Legal and administrative costs (costs associated with the
litigation arising from liquidation or bankruptcy such as lawyer’s
fees, courtroom costs, etc.)

Indirect costs
 Impaired ability to conduct business (decrease confidence of
customers and suppliers, etc.)
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Exercise 3

Your firm is considering issuing one-year debt, and has come up
with the following estimates of the value of the interest tax shield
and the probability of distress for different levels of debt:
Debt Level ($ million)
0

40
50
60
70
80
90
PV (interest tax shield, $ million) 0.00
0.76
0.95
1.14
1.33
1.52
1.71
Probability of financial distress
0%
1%
2%
7%
16%
31%
0%
Suppose the firm has a beta zero, so that the appropriate discount
rate for financial distress costs is the risk-free rate of 5%. Which
level of debt above is optimal if, in the event of distress, the firm
will have distress costs equal to



$2 million?
$5 million?
$25 million?
(Berk and DeMarzo)
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Exercise 4

Hawar International is a shipping firm with a current share price of
$5.50 and 10 million shares outstanding. Suppose Hawar
announces plans to lower its corporate taxes by borrowing $20
million and repurchase shares.


With perfect capital markets, what will the share price be after this
announcement?
Suppose that Hawar pays a corporate tax rate of 30%, and that
shareholders expect the change in debt to be permanent.

If the only imperfection is a corporate taxes, what will share price be
after this announcement?
 Suppose the only imperfection are corporate taxes and financial
distress costs. If the share price rises to $5.75 after this
announcement, what is the PV of financial distress costs Hawar will
incur as the result of this new debt? (Berk and DeMarzo)
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Agency costs/benefits of leverage

Agency costs of leverage
 Over-investment problem
 Under-investment problem
 Cashing out problem

Agency benefits of leverage
 e.g. Leverage reduces excess cash flow and the
wasteful investments by managers
VL=VU + PV(interest tax shield) – PV(financial distress costs)
– PV(agency cost of debt) + PV(agency benefits of debt)
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