Long-Term Financing
Question 1
Suppose that a firm is operating with neutral corporate and personal taxes in an otherwise perfect capital market and Equation (I6.7) currently holds. In such a world, a firm would never take on any risky debt. Why not? (Hint: Consider what would happen in financial distress).
When a firm is operates in an environment with neutral corporate and personal taxes imply that the source of financing has no impact on the tax liability of the firm. Normally, companies usually borrow debt to reduce their tax liability by deducting interest expense. Interest expense is an allowable expense for tax purposes, it therefore shields part of a company’s income from tax thus reducing the tax liability. In an environment with neutral taxes and perfect market capital markets, a company will reduce its risky debt.
Firms will opt for less risky debt because it imposes a financial obligation on the firm to pay interest and the principal sum as and when it is due. Failure to pay interest and the principal sum may lead to financial distress, bankruptcy and eventually liquidation. Firms would therefore opt to finance operations using equity since unlike, debt, payment of dividend is optional and the amount varies with the performance of the company. Secondly, the company is not expected to repay the par value. Equity financing, therefore lowers the financial risk of a company.
The company may still need some level of debt financing because there are some advantages of risky debt over equity. Debt financing allows owners of the business to retain control and ownership of the business since debt providers are creditors. Secondly, obligations of debt finance are limited to financing of the loan. Therefore creditors do not participate in division of extra earnings of the company. Lastly, debt financing can be raised faster than equity financing since there are fewer legal procedures to comply with. Therefore, in an environment with neutral taxes, a company may opt to reduce the amount of risky debt however it may not completely do away with risky debt.
Question 2
Using agency theory concepts, explain how restrictive covenants that forbid leases and liens on a firm's assets might cause the firm to achieve a higher rating on its bonds than would be possible without such covenants.
Agency theory in finance is concerned with the conflicting interests of various stakeholders in a company and how they can be resolved. Conflict of interest can be classified into two broad groups; shareholders and management and shareholder and creditors. Conflict of interest arises between shareholders and management because managers have personal interests that affect shareholders wealth maximization. Conflict of interest between creditors and shareholders arise because creditors lend to companies based on their riskiness and expect the company to avoid risky ventures so that they can be assured of their principal and interest due. On the other hand, shareholders encourage management to undertake risky projects that would maximize their wealth. One of the ways of solving the shareholder-creditor conflict is by restrictive convents. Restrictive covenants are bond covenants that prohibit the borrowing company from undertaking certain actions such as issuing additional debt.
In this case, a restrictive covenant that prohibits liens and leases on a company's assets will result in a firm having a higher credit rating because bond rating depends on the riskiness of a company and its capital structure. This debt covenant will decrease agency costs that are related with the conflict of interest between shareholders and creditors by protecting investors from default risk. This is because it will ensure the leverage ratio is low. A low leverage ratio ensure that the there is a low possibility of the company failing to pay its liabilities as and when they fall due. Therefore, there is a low probability of the firm going into financial distress. It also ensures that the assets of the company are not held up and can easily be sold to meet bond holder’s claims in case of financial distress. Therefore, such a company is likely to have a high bond rating.
Question 3
Assume that IBM is selling for $180 per share. IBM implements one of the following stock dividends or stock splits, and no other change in the value of the firm occurs. What is the value of one share for each of me following? An 8% stock dividend. A 50% stock dividend.
P = D1/ (1 + Ke)
Where;
P is the value of each share
D1 is the dividend per share which is 8%*180 = 14.4
Ke is the cost of ordinary shares which is 8%
Therefore;
P = 14.4/ (1+0.08) = $ 13.3
Value of each share = stock splits percentage* Market price per share
= 50%*180 = $ 90
Question 4
Next year dividend = Current dividends + Portion of extra earning per share to be distributed
= 0.4 + 30% *(7.5-6) = 0.85
References
Emery, D. R., Finnerty, J. D., & Stowe, J. D. (2007). Corporate financial management (3, revised ed.). New Jersey: Prentice Hall.
Brigham, E. F., & Ehrhardt, M. C. (2010). Financial Management Theory and Practice (13 ed.). London: Cengage Learning.
Vishwanath, S. R. (2007). Corporate Finance: Theory and Practice. New York: SAGE.
