Question

Discuss Briefly:

(a) The more debt a firm issues, the higher interest rate it must pay; thus firms should operate at conservative debt levels.

(b) Given the choice between two investment projects with the same systematic risk and the same expected return, all bondholders would prefer the project with the lower variance and all stockholders would prefer the project with the higher variance.

(c) Black-Sholes is inappropriate for valuing a levered firm’s equity, the empirical evidence indicates that higher interest rates are associated with lower stock prices.

Answer 1

1. The firm should not operate at conservative debt level rather it should operate at the optimum level which is somewhere between conservative and aggressive level. Because even if the debt incurs interest payments they are tax deductible and a firm's value increases with increase in debt till the optimum level. Because after that level, bankruptcy costs are more than the tax benefits of debt as interest rate rises high.

2. Total risk is captured though variance. And there can be cases that in certain situations -in any state the stockholders dont make much money because cash flow is only able to service bondholders. Therefore, they would like higher variability that anyways they are not making money but due to higher variability there is a chance that they might make money in certain situations but as this puts a risk to service the bondholders they would want lower variance. Bondholders are guaranteed fixed payments hence they want lower variance investments. Stockholders get whatever is left from bondholders so they want higher variance investments.

3.

Firstly, Black Scholes is appropriate for valuing levered firm's equity because then only the optionality component comes into picture.

Secondly, it is not due to higher interest rates, stock prices are lower but due to higher leverage there is higher volatility and due to higher volatility one might associate higher leverage with falling stock prices. However, this is anomalous because of following observations : effect is much nonexistent when positive stock returns decrease leverage; the effect is too small with measured leverage in case of individual firms, but too large for exchange implied volatilities. Also, volatility change associated with change in leverage appears to fizzle out over few months. There seems to be no apparent effect on volatility in case of change in leverage due to change in outstanding debt/shares, only when the stock prices change. hence, empirical evidence suggests that "leverage effect" is in reality "down market effect" having little direct connection to firm leverage.