Question

chapter is about FINANCIAL LEVERAGE AND CAPITAL STRUCTURE POLICY

1. Identify the impact of taxes ad bankruptcy on capital structure choices.

2. What are the essentials of the bankruptcy process?

3. What is the relationship between the value of an unlevered firm and the value of a levered firm once we consider the effect of corporate taxes?

Answer 1

1.

Taxes provide a benefit for companies with debt and interest repayments. The interest repayment is tax deductible for the companies and creates a tax shield equal to interest payment * tax rate. Hence, higher the tax rate, higher is the tax shield. As the debt on the balance sheet increases, the interest portion and the tax shield increases, which in turn increases the returns for the equity holders. However, the leverage impact also magnifies the impact of loss or EBIT less than required to cover the interest payments. In such case, the equity holders experience a magnified impact on their loss. The relationship between taxes and tax shield is linear. Hence, in regions with higher tax rates, the capital structure leans more towards debt than equity. Too much debt in the balance sheet creates unsustainable interest liability. The cost of debt increases in kinks (steps) as the leverage on the balance sheet increases. Bankruptcy in the history of the company has long term impact and the interest rate are higher for a company which had faced bankruptcy for as long as 10-12 years after it has come out from bankruptcy.

2.

Corporates can file bankruptcy under chapter 11 of the bankruptcy code in the US. A bankruptcy filing goes through following steps which are required to be followed while filing for bankruptcy-

Petition- a complete list of the company’s assets, liabilities, incomes and expenses and a summary of financial affairs need to be submitted to and reviewed by the bankruptcy office. This triggers an automatic stay on the claims of the creditors

Monthly operating reports- a monthly report of financial affairs needs to be submitted for as long as the proceedings may take place

Debtor interview and creditors meetings- the bankruptcy filler needs to meet with the trustee and with the creditors to discuss the details on the filling

Disclosures- the debtor needs to file disclosures and reorg plan to every party of interest. This plan includes the details of how each creditor will be treated, priority of debt obligations etc.

Confirmation- the plan is approved, accepted and confirmed by the judge and the interested parties after which it comes into effect

Periodic payments- once the plan is approved, the debtor must make approved payments to the court to service the claims. The repayment plan becomes contractual obligation for the debtor.

3.

The corporate taxes provide a tax shield benefit for the levered firm. The value of levered firm is expected to be higher than the otherwise similar unlevered firm. The difference would be approximately equal to the present value of the tax shield, discounted at the levered cost of capital. There are two factors that add value. First is the dollar benefit from the tax shield i.e. leverage and the other is lower cost of capital. The cost of debt is usually lower than the cost of equity. The corporate tax lowers the cost of debt even lower to an extent of (1- tax rate). Hence, the WACC or the discount rate for the cash flows of levered firm becomes lower. This adds to the value of the levered firm. The volatility of returns for the equity holders is higher due to the additional leverage. However, the corporate tax lowers the volatility of the cash flows and consequently the value of firm. Generally, as the tax rate increases, the value of levered firm increases as the tax shield increases, compared to an otherwise similar unlevered firm.