AFM373 Lecture Notes - Lecture 11: Morgan Stanley, Tax Shield, Investment Policy

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lilacmouse857

3 Jul 2018

School

University of Waterloo

Department

Accounting & Financial Management

Course

AFM373

Professor

Neil Brisley

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Morgan Stanley Roundtable on Capital Structure

Capital structure theory

Original assumption

No tax

oNo tax shields

No cause of financial distress

oNo Risk of bankrupt

Investment policy is fixed

First case

Capital structure is irrelevant to the value of the firm.

More debt will eventually increase cost of debt even if we assume it is default free (no

cause of financial distress)

More debt will also eventually increase cost of equity

WACC doesn't change because value of the firm doesn't change.

So it doesn't matter if the percentage of D and E is 90-10 or 60-40, the value of the

whole doesn’t change.

Second case

If there are corporate tax, what would change?

Interest tax shield

Cost of debt will decrease (1-t) than first case. But still increase as firm take more debt.

Cost of equity will increase

WACC will decrease because cost of debt decreased

Firm value will increase because of tax shields.

Third case

There is tax and cost of financial stress

More debt = more likely of financial stress

Cost of debt and equity will go up a little sharply

WACC will decrease first due to tax benefits and then increase due to costs of financial

distress

Value will increase first and the decrease like a parabola shape.

As CFO of the firm, we want to maintain at the middle point before WACC starts to

increase and value starts to decrease.

D/V ratio differs by industry

e.g. 91% debt in financial services because they borrow and lend as their service.

It's our job to understand what firm and situation leads it to low debt or high debt.

Effect of leverage

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Document Summary

No cause of financial distress: no risk of bankrupt. Capital structure is irrelevant to the value of the firm. More debt will eventually increase cost of debt even if we assume it is default free (no cause of financial distress) More debt will also eventually increase cost of equity. Wacc doesn"t change because value of the firm doesn"t change. So it doesn"t matter if the percentage of d and e is 90-10 or 60-40, the value of the whole doesn"t change. Cost of debt will decrease (1-t) than first case. But still increase as firm take more debt. Wacc will decrease because cost of debt decreased. Firm value will increase because of tax shields. There is tax and cost of financial stress. More debt = more likely of financial stress. Cost of debt and equity will go up a little sharply. Wacc will decrease first due to tax benefits and then increase due to costs of financial distress.

Related Questions

1. Your company pays interest on its 3 year, 6% coupon rate debt as follows: Year 1: $50 million Year 2: $40 million Year 3: $30 million The tax rate is 40%. What is the present value of the interest tax shield if the discount rate is 8%? 48 mil 41.76 mil 52.23 mil 32.18 mil

2. How does the interest deduction from taxes affect the conclusions of the MM Propositions? Firm value increases with leverage but WACC remains constant. Firm value decreases with leverage, and WACC is unaffected. Firm value decreases with leverage, and WACC inreases with leverage. Firm value increases with leverage and WACC decreases with leverage..

3.Which of the following is true about agency considerations in finding the optimal capital structure for a firm? No answer text provided. Outside equity costs more than debt, and debt costs more than retained earnings due to information asymmetry. Therefore, finance project with retained earnings first, debt second, and outside equity last. Through their control of management, stockholders will take more risk than what is in bondholders' interets. The optimal level of debt is determined by trading off the benefits of deducting interest from taxes and the costs of financial distress.

skyhedgehog100

F2 Q1-5

The return on equity of a typical firm may change over time because of changes in business and economic conditions, but it is unlikely to change based on the financing or capital structure of the firm.

a. False.

b. True.

Your firm has been plodding along without much attention from the stock market. Your boss insists that he can (a) increase the return on assets to shareholders by taking on more debt, and (b) attract new investors to the firm due to the higher returns.

a. False.

b. Partly true, partly false.

c. True.

Even in a world with no frictions â that is, taxes, costs of bankruptcy, asymmetric information â debt will always be preferred because cost of debt is always lower than cost of equity for a firm.

a. True.

b. False.

c. Partly true, partly false.

In a world with taxes and bankruptcy costs, and in which interest on debt is tax deductible, if a firm has some debt:

a. The return on equity is less than the weighted average cost of capital (WACC).

b. The return on equity is greater than the weighted average cost of capital (WACC).

c. The relationship between return on equity and the WACC cannot be determined because it depends on several factors.

In the real world, where there are taxes and interest on debt is tax deductible, if two firms have the same cash flows as each other in all possible scenarios in the future, the returns on equity of the two firms will:

a. Will depend on the capital structures adopted by the firms.

b. Will depend on the capital structures adopted by the firms and the valuation method used.

c. Always be equal to each other.

d. Will depend on the method of valuation used.

V2 F1 Q1-5

Please give explanations

1) The return on assets of a typical firm may change over time because of changes in business and economic conditions, but it is unlikely to change based on the financing or capital structure of the firm with reasonable amounts of debt.

a) True

b) False

2) Your firm has been plodding along without much attention from the stock market. Your boss insists that he can (a) increase the return on equity to shareholders by taking on more debt, and (b) attract new investors to the firm due to the higher returns.

a) False

b) Partly true, partly false

c) True

Q3) In a world with no frictions â that is, taxes, costs of bankruptcy, asymmetric information - there is no optimal capital structure (that, is no optimal mix of debt and equity).

a) True

b) False

Q4) In a world with taxes and bankruptcy costs, and in which interest on debt is tax deductible, if a firm has some debt:

a) The relationship between return on assets and the WACC is indeterminate and depends on several factors.

b) Its return on assets is always greater than the weighted average cost of capital (WACC).

c) Its return on assets is always is equal to the weighted average cost of capital (WACC).

d) Its return on assets is always less than the weighted average cost of capital (WACC).

Q5) In the real world, where there are taxes and interest on debt is tax deductible, if two firms have the same cash flows as each other in all possible scenarios in the future, their valuation at any point will:

a) Will depend on the capital structures adopted by the firms.

b) Will depend on the method of valuation used.

c) Will depend on the capital structures adopted by the firms and the valuation method used

d) Will be the same as each other regardless of the method of valuation.

AFM373 Lecture Notes - Lecture 11: Morgan Stanley, Tax Shield, Investment Policy

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