18 How Much Should a Firm Borrow.ppt

Slides by Matthew Will Topics Covered Corporate Taxes and Value Corporate and Personal Taxes Cost of Financial Distress Pecking Order of Financial Choices C.S. Corporate Taxes Financial Risk - Risk to shareholders resulting from the use of debt. Financial Leverage - Increase in the variability of shareholder returns that comes from the use of debt. Interest Tax Shield- Tax savings resulting from deductibility of interest payments. C.S. Corporate Taxes Example - You own all the equity of Space Babies Diaper Co.. The company has no debt. The company’s annual cash flow is $1,000, before interest and taxes. The corporate tax rate is 40%. You have the option to exchange 1/2 of your equity position for 10% bonds with a face value of $1,000. Should you do this and why? C.S. Corporate Taxes Example - You own all the equity of Space Babies Diaper Co.. The company has no debt. The company’s annual cash flow is $1,000, before interest and taxes. The corporate tax rate is 40%. You have the option to exchange 1/2 of your equity position for 10% bonds with a face value of $1,000. Should you do this and why? C.S. Corporate Taxes Example - You own all the equity of Space Babies Diaper Co.. The company has no debt. The company’s annual cash flow is $1,000, before interest and taxes. The corporate tax rate is 40%. You have the option to exchange 1/2 of your equity position for 10% bonds with a face value of $1,000. Should you do this and why? Capital Structure PV of Tax Shield = (assume perpetuity) Capital Structure Firm Value = Value of All Equity Firm + PV Tax Shield C.S. Taxes (Personal Corp) C.S. Taxes (Personal Corp) C.S. Taxes (Personal Corp) C.S. Taxes (Personal Corp) Today’s RAF Debt vs Equity preference. Capital Structure Financial Distress Costs of Financial Distress - Costs arising from bankruptcy or distorted business decisions before bankruptcy. Financial Distress Costs of Financial Distress - Costs arising from bankruptcy or distorted