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Corporate Finance

Tutorial 8 Suggested Solutions

Corporate Finance
Tutorial 8: Capital Structure
Suggested Solutions
Sample Examination Question 1
The assumptions underlie Modigliani and Millers proposition of firm value should be
independent of capital structure are as follows:
! Financing decisions do not affect the return from physical investments
! Capital markets are frictionless or perfect
Unlimited borrowing and lending opportunities at Rf
No Taxes
No transaction costs
! Investors are rational and care only about their wealth
Prefer more than less
Dont mind whether the wealth is in cash or capital gain
! Investors and insiders have equal access to information and have same expectations
regarding the future
Sample Examination Question 2
!

!
!

!
!

2 firms:
Unlevered all-equity firm and
Levered firm with B units of debt at RD
An investor holding the same ! proportion of unlevered firms equity and levered
firms equity and debt
2 possible outcomes 1 period ahead
Cash flow from firm > Face value of its debt or
Cash flow from firm < Face value of its debt B
Let X represents the firms cash flow
Payoff for the investor under the 2 scenarios for both unlevered and levered firms are
as follows:
Payoff for Unlevered Firm

Payoff for Levered Firm

X < B(1 + RD)

X > B(1 + RD)

X < B(1 + RD)

X > B(1 + RD)

!X

!B(1 + RD)

Equity

!X

!X

![X " B(1 + RD)]

Total

!X

!X

!X

!X

Debt

!
!

All investment income are the same => All investment should have the same value
Conclusion: Investor is indifferent to a firms financing decision (or capital structure)

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Sample Examination Question 3


!

With personal and corporate tax, the value of a levered firm is

Interest payments are tax deductible for the firm & taxable as income for debt
investor resulting in a net amount of rdD(1 ! Td)

Firms taxable profit in period t is EBITt rdD resulting in income payable to equity
holders of (EBITt rdD)(1 Tc) before personal tax

After considering personal tax, the net income to the equity holders will be
(EBITt rdD)(1 Tc)(1 Te)

Therefore, total payments to both debt and equity holders respectively in a certain
period t is
Ct = (EBITt rdD)(1 Tc)(1 Te) + rdD(1 ! Td)
Ct = Net Income to Equity Holders + Net Income to Debt Holders
Ct = EBITt (1 Tc)(1 Te) rdD(1 Tc)(1 Te) + rdD(1 ! Td)
Ct = EBITt (1 Tc)(1 Te) + rdD[(1 ! Td) (1 Tc)(1 Te)]

Ct = Cash Flows to Equity Holders + Tax Shield on Debt


Discounting the perpetual CFs to equity holders by re and tax shield on debt by rd(1 !
Td) will result in

Proof for RHS 2nd term of the above equation:

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If only corporate taxation exist then Te = Td = 0 resulting in

Conclusion:
To maximise the firms value in a world of corporate tax only, the firm should take on as
much debt as possible
Note:
Optimal Capital Structure will be neither all-equity nor all-debt if bankruptcy cost is
considered, as the value of levered firm will now be
VL = VU + DTc ! PV(Corporate Distress)

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Corporate Finance

Tutorial 8 Suggested Solutions

Suggested Solution to FE 2007 Zone B Question B5(a) & (b)


(a)
In a levered firm, equity-holders will only receive residual cash flows accruing to
the firm after repayment of X made to debt-holders. Hence, when firms cash
flow is at or less than the face value of debt (X), equity-holders receive nothing.
This gives rise to a kinked payoff function for equity-holder which is precisely
the same function as that of the European call option with exercise price equal to
X.
Debt-holders, on the contrary, will gain the entire amount of the cash flow
accruing to the firm up to the face value of debt. Hence, the payoff function can
be replicated by a risk-free investment paying the debt amount and
simultaneously writing a put option to strike at X.
The sum of the values of the firms debt and equity must be equal to the value of
the firms assets, V. Hence, the equity and debt claim can be thought of as a
financial package containing various types of claims.
The following equation gives the put-call parity. Under the conditions that the
call and put options have the same exercise price, time to maturity and
underlying asset, put call parity will hold. Thus
S0 + p = c + PV(X)
Where X is the exercise price and is equal to the face value of the firms debt.
From the above analysis, and to re-arrange the equation, the sum of the debt
holder and equity holders positions of a levered firm will be as follows:
c p + PV(X) = S0
Hence, the put-call parity implies Modigliani-Miller irrelevance.
(b)
The existence of corporate taxation and costly bankruptcy means that Modigliani
and Millers analysis of capital structure irrelevance is violated. As the debtequity ratio increases, there is a tradeoff between the interest tax shield and cost
of bankruptcy, leading to an optimal capital structure. This is known as the
trade-off theory of capital structure. With this optimum debt-equity ratio comes
the predictions of level of corporate borrowing.

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Corporate Finance

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Suggested Solution to FE 2007 Zone B Question B6(c)


The Debt overhang problem identified by Myers (1977) is a form of agency cost
of debt.
It states that when debt levels are high, the management of firms, acting in the
interest of current shareholders, will choose to reject some positive NPV project
as little of that projects payoff will accrue to equity-holders. As a result, heavily
indebted firms will see reduction in corporate value. Apart from firms with high
borrowing, corporations with little worth of tangible assets that can act as
security for their borrowing or high growth firm (whose assets may still be
investment projects due to be started rather than actual investments) will also
suffer debt overhang problem. To protect itself from this type of problem, a firm
should aim for low level of debt, short maturity as opposed to long maturity
debt, debt covenants, convertible debt, corporate governance etc.

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Suggested Solution to FE 2007 Zone B Question B7(b) & (c)


(b)
In an overall-equity firm, where management holds a proportion of the equity,
Jensen and Meckling argue that firm values are lower than would be if
management were sole owner.
Manager is the agent of the owners and is supposed to undertake activities that
add value to the firm. However, with the presence of outside equity, manager
will not be able to enjoy the full performance that resulted from his effort. Any
increased effort supplied by manager leads to greater firm value which benefits
owners but at a cost to the manager. Hence, it may not make sense for the
manager to bear the entire cost of effort supply and reap only a portion of the
benefit. This induces the manager to supply lower levels of effort, resulting in
lower firm value when proportion of equity held by outsiders is increased. This
is known as agency cost of outside equity.
One possible solution to this agency cost of outside equity is to finance the firm
using more debt and less outside equity. Alternatively, firm can choose to
repurchase outside equity with debt. Both strategies lead to increase in
managers proportion of the firm outstanding equity.
Therefore, as the proportion of outstanding equity held by manager increases
with leverage, the manager chooses to put in more effort, leading to increase in
form value.
This implies that as leverage increases, agency cost of outside equity decreases.
(c)
As explained above, one possible solution to agency cost of outside equity is to
issue debt. However, issuing debt may only be a partial but is certainly not a full
answer, as there are also agency costs of debt.
With increasing debt (high level of debt-equity ratio), the value of the firm may
be lower as manager, acting in the interest of the equity holders, chooses to reject
low-risk high expected return project. Manager will choose the project that will
maximize the equity holders value at the expense of the debt holders. This is
known as asset substitution or risk shifting problem highlighted by Jensen &
Meckling.
Combining the two agency costs, it can be argued that an optimal capital
structure might exist
Agency cost of outside equity decreases with leverage, and
Agency cost of debt increases with leverage.
" Firm value would be maximized when total agency costs are minimized,
leading to the optimal leverage ratio.

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Suggested Solution to FE 2008 Zone B Question B5(a) & (b)


(a)
In an overall-equity firm, where management holds a small proportion of the
equity, Jensen and Meckling argue that firm values are lower than would be if
management were sole owner.
Manager is the agent of the owners and is supposed to undertake activities that
add value to the firm. However, with the presence of outside equity, manager
will not be able to enjoy the full performance that resulted from his effort. Any
increased effort supplied by manager leads to greater firm value but it costs the
manager. Hence, it may not make sense for the manager to bear the entire cost of
effort supply and reap only a portion of the benefit. This induces the manager to
supply lower levels of effort resulting in lower firm value when proportion of
equity held by outsiders is increased. This is known as agency cost of outside
equity.
Graphical representation of the agency cost of outside equity is given below:

One possible solution to this agency cost of outside equity is to finance the firm
using more debt and less outside equity. Alternatively, firm can choose to
repurchase outside equity with debt. Both strategies lead to increase in
managers proportion of the firm outstanding equity.
Therefore, as the proportion of outstanding equity held by manager increases
with leverage, the manager chooses to supply more effort, leading to increase in
firm value. This implies that as leverage increases, agency cost of outside equity
decreases.

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(b)
Myers-Majluf (1984) pecking order theory of finance concentrates on the
information revealed by security issues under asymmetric information market.
Extending the theory to cover riskless and risky debt as well as equity : When a
firm issues riskless debt, it does not convey any information to the market since
there is no default possibility. This does not allow the firm to exploit the market
and therefore equity prices do not react to the issue. Only high-quality firms will
be able to issue riskless debt.
As for risky debt, there is a possibility of default and hence the security could be
mis-priced. Market will over-priced the debt when it under estimated the
probability of default. Thus, issues of risky debt convey some information to the
market but less clearly than the issuance of equity. Compared to equity issuance,
the equity prices will fall by a smaller amount when risky debt is issued. Equity
issues cause stock prices to drop a lot as the market infers that firms that issue
are of very poor quality.
The choice of security issuance, which results in a change in a firms capital
structure, affects firm value. Therefore, it can be more costly to issue equity than
to issue debt for corporations.
One of the many reasons for company to repurchase its own share is to signal
managers belief that the companys share is under-valued, and by financing the
share buyback scheme via retained earnings (riskless debt) is to deploy its excess
cash flow and/or substitute cash dividend payment. That reassures market of
the firms quality on one hand, but can increase the cost of capital for future
investments on the other hand. Hence, the net effect is ambiguous

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Corporate Finance

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Suggested Solution to FE 2008 Zone B Question B6


(a)
In a levered firm, equity-holders will receive cash flows accruing to the firm
after repayment of X made to debt-holders. Hence, when firms cash flow is at
or less than the face value of debt (X), equity-holders receive nothing. This gives
rise to a kinked payoff function for equity-holder which is precisely the same
function as that of a European call option with exercise price equal to X.
Debt-holders, on the contrary, will gain the entire amount of the cash flow
accruing to the firm up to the face value of debt. Hence, the payoff function can
be replicated by a risk-free investment paying the debt amount and
simultaneously writing a put option to strike at X.
The sum of the values of the firms debt and equity must be equal to the value of
the firms assets, V. Hence, the equity and debt claim can be thought of as a
financial package containing various types of claims.
The following equation gives the put-call parity. Under the conditions that the
call and put options have the same exercise price, time to maturity and
underlying asset, put call parity will hold. Thus
S0 + p = c + PV(X)
Where X is the exercise price and is equal to the face value of the firms debt.
From the above analysis, and to re-arrange the equation, the sum of the debt
holder and equity holder positions of a levered firm will be as follows:
c p + PV(X) = S0
which is equivalent to
Value of equity + Value of debt = Value of firm
Hence, the put-call parity implies Modigliani-Miller irrelevance.

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(b)
The Debt overhang problem identified by Myers (1977) is a form of agency cost
of debt. It demonstrates that when debt levels are high, the management of firms,
acting in the interest of current shareholders, will choose to reject some positive
NPV projects as little of that projects payoff accrues to equity-holders. As a
result, even in the absence of bankruptcy costs, heavily indebted firms will see
reductions in corporate value. Apart from firms with high borrowing,
corporations with little worth of tangible assets that can act as security for their
borrowing or high growth firm (whose assets may still be investment projects
due to be started rather than actual investments) will also suffer debt overhang
problem. To protect itself from this type of problem, a firm should aim for low
level of debt, short maturity as opposed to long maturity debt, include debt
covenants in loan document, issue convertible debt, corporate governance etc.
(c)

Given

Rf = 0.05

V0 = $1,000,000

VH = $1,800,000

B = $ 600,000

VL = $ 500,000

Maturity Payoff for Call : KH = 1,200,000


KL = 0
aVH + b(1 + Rf) = KH

Equation 1

aVL + b(1 + Rf) = KL

Equation 2

a ($1,800,000 - $500,000) = $1,200,000 - $0

Equation 1 2

a = $1,200,000 / $1,300,000 = 0.9231


Substitute a into Equation 2
b (1 + 0.05) = 0.9231 x $500,000
b = 461,550 / 1.05 = 439,571
c = a V0 + b = (0.9231) (1,000,000) + ( - 439,571) = $483,529
Hence VE = $483,529

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Suggested Solution to FE 2008 Zone B Question B7(a)

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Suggested Solution to FE 2008 Zone B Question B8(a) & (b)


(a)
Asset Substitution or Risk Shifting problem associated with debt finance was first
highlighted by Jensen and Meckling in 1976. Risk shifting refers to the negative
effect of holding debt, thereby compensating the positive effect from using debt.
With increasing debt (high level of debt-equity ratio), the value of the firm may
be lower as manager, acting in the interest of the equity holders, chooses to reject
low-risk high-expected return project. Instead high-risk low-expected return
project will be chosen as it will maximise the equity holders value at the expense
of the debt holders.
Example
Assume a manager runs a levered firm in the interest of equity-holders and is
given two investment projects assumed to have zero cost and mutually exclusive.
Cash flows for he two projects are given I the table below. Manager has to choose
one of the two projects.
State 1

State 2

State 3

Expected NPV

Probabilities

0.25

0.50

0.25

Cash Flow A

40

50

60

50

Cash Flow B

20

40

80

45

Both projects expected to have positive NPV with Project A having lower risk
and higher expected NPV of 50 while Project B is riskier with lower expected
NPV of 45. Clearly project A is superior to project B.
Now, lets assume debt-holders have a claim of 50 that must be repaid from the
chosen project.
Project A
Only in Stage 3 will equity-holders get a pay-off of 10 (i.e. 60 50) implying an
expected pay-off to equity-holders of 10 x 0.25 = 2.50 while the expected pay-off
to debt-holders is (0.25 x 40) + (0.50 x 50) + (0.25 x 50) = 47.50.
Project B
Only in Stage 3 will equity-holders get a pay-off of 30 (i.e. 80 50), implying an
expected pay-off to equity-holders of 30 x 0.25 = 7.50 while the expected pay-off
to debt-holders is (0.25 x 20) + (0.50 x 40) + (0.25 x 50) = 37.50.
Manager will choose Project B as it maximises expected pay-off to equity-holders
but debt-holders are worse off since the firms value is lower when Project B is
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chosen i.e. expected NPV of 50 for Project A vis--vis 45 for Project B. Debtholders in this case will bear the cost of asset substitution.
However, if debt repayment were 30 then expected pay-off to equity-holder are
as follows:
Project A:

(0.25 x 10) + (0.50 x 20) + (0.25 x 30) = 20

Project B:

(0.50 x 10) + (0.25 x 50) = 17.50

Manager will then choose Project A which will cause debt-holders to be happy as
their pay-offs are better as well:
Project A:

(0.25 x 30) + (0.50 x 30) + (0.25 x 30) = 30

Project B:

(0.25 x 20) + (0.50 x 30) + (0.25 x 30) = 27.50

Therefore, when the face value of debt is lower, the manager will choose the lowrisk, high-expected return project. This implies that the lower the debt, the higher
the firm value.
In conclusion, capital structure of a firm affects the value of the firm and this
relationship can be represented graphically as follows:

To mitigate this problem, a firm should aim for low level of debt, short maturity
as opposed to long maturity debt, and/or use of convertible debt to finance new
projects.

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(b)
The crux of Ross (1977) signaling argument for debt is as follows:

Firms differ according to their future cashflow prospects


High quality firms has large future cashflow whereas low quality firms
has small future cashflow
Firm quality is not observable to outsiders of the firm "Asymmetric
information
Managers of high quality firms have an incentive to signal their quality to
the market
One way to signal is through debt policy as high quality firm will choose
high leverage ratios and low quality firm choose low leverage ratios.
Leverage is a credible signal as it is assumed that managers are risk
averse, hence only managers of high quality firms are willing to expose
themselves to the potential risk of bankruptcy.

[Please show the mathematical expression here if required].


Therefore, it implies a positive relationship between debt ratio and firm values.
Capital structure can signal information to investors.

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Suggested Solution to FE 2009 Zone B Question B5


Part (a)
!

With personal and corporate tax, the value of a levered firm is

Interest payments are tax deductible for the firm & taxable as income for debt
investor resulting in a net amount of RdD(1 ! Td)

Firms taxable profit in period t is EBITt RdD resulting in income payable to


equity holders of (EBITt RdD)(1 Tc) before personal tax

After considering personal tax, the net income to the equity holders will be
(EBITt RdD)(1 Tc)(1 Te)

Therefore, total payments to both debt and equity holders respectively in a


certain period t is
Ct = (EBITt RdD)(1 Tc)(1 Te) + RdD(1 ! Td)

To re-arrange the cashflow to each stakeholder:


Ct = Net Income to Equity Holders + Net Income to Debt Holders
Ct = EBITt (1 Tc)(1 Te) RdD(1 Tc)(1 Te) + RdD(1 ! Td)
Ct = EBITt (1 Tc)(1 Te) + RdD[(1 ! Td) (1 Tc)(1 Te)]

Ct = Cash Flows to Equity Holders + Tax Shield on Debt


Discounting the perpetual CFs to equity holders by Re and tax shield on debt
by Rd(1 ! Td) will result in

If Td = Te , the above equation will be reduced to


VL = VU + DTC
implying that firms would be maximizing their values by issuing as much debt
as possible.

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Part (b)
The Trade-Off Theory of Capital Structure refers to the idea that a company
chooses how much debt finance and how much equity finance to use by
balancing the costs and benefits. Proposition I & II of Modigliani and Miller
states that:
I: Value of a Levered Firm = Value of an Unlevered Firm + Value of the Tax
Shield, implying that firms which want to maximize their values should
maximise their level of debt.
II: Increase in debt will increase the financial risk of equity. Therefore,
Re = Ra + (Ra Rd)(1 - Tc) *D/E
Non-trivial costs of financial distress or bankruptcy shows that cost of debt
(return + financial distress) and the benefits of tax shield arising from debt, a
firm should try to maximise its value by carefully trading off these two effects.
Therefore one might suggest that the optimal capital structure exists when the
marginal cost of financial distress = the marginal tax shield effect.
Firm Value

PV (bankruptcy cost)
PV (Interest
tax shield)
Value of

Unlevered Firm
D/E*

D/E

As the Debt equity ratio (ie leverage) increases, there is a trade-off between the
interest tax shield and bankruptcy, causing an optimum capital structure, D/E*

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Part (c)
(i) With the backing from the government, the potential bankruptcy cost
would be low for this water company. The high profit that the company
is generating will be able to absorb the interest on debt, thereby
enhancing the tax advantage from debt.
Based on the Trade-off Theory, this company is likely to have a higher
level of debt.
(ii)

The success of the high-end-cutting-edge R&D activities carried out by


this biochemical company is uncertain due to its high risk. Its profit may
fluctuate a lot, making it difficult to take full advantage of the debt tax
shield.
Based on the Trade-off theory, this company is likely to have a relatively
lower debt equity ratio.

(iii) This advertising company is unlikely to have sufficient profits to provide


the maximum tax shield as a result of past years cumulated losses. Debt
might also be risky as the company is relatively young. It might also
have potentially higher bankruptcy costs.
Based on the Trade-off theory, this company is likely to have very low
level of debt.

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Suggested Solution to FE2010 Zone B Question A2


(a)

To calculate the companys # before the project (#A)


Given # D = 0
#A

= WD # D + W E #
=

D(1-Tc ) # D +
E
#E
D(1-Tc ) + E
D(1-Tc ) + E

=0 +

60_______ (1.20)
40 (1 - 0.4) + 60

60
(1.20) = 0.8571
24 + 60

(b)
To calculate the companys MV after proposed project and financing
option
Market Value of Firm (before project) = 100mm
$
VD = 0.4 (100 mm ) = 40mm
VE = 60mm
If project is undertaken and financed by equity
VD
New VE

= 0.3
0.7

or
VD
New VF
$

New VF =

0.3
1
VD
0.3

40
0.3

= 133.33 mm

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(c)

Tutorial 8 Suggested Solutions

NPV of Project
New VF
$

= VD + New VE

New VE = New VF - VD
= 133.33 mm 40mm
= 93.33 mm

NPV Project = New VE - Old VE


= 93.33 mm - 60mm
= 33.33 mm
(d)

Companys #E after the project (New #E )


#A

= WD # D + W E #
=

D(1-Tc ) # D +
D(1-Tc ) + E

E
#E
D(1-Tc ) + E

= D(1-Tc ) # D + E# E_
D(1-Tc ) + E
# A [D(1-Tc ) + E] = D(1-Tc ) # D + E# E
E# E = D(1-Tc ) (# A - # D ) + # A E
# E = # A + D (1- TC ) [# A - # D]
E
= 0.857 + 0.3 (1 0.4) [0.857 0 ]
0.7
= 0.857 +

0.18_ (0.857)
0.7

= 0.857 + (0.2571) (0.857)


= 0.857 + 0.2204
= 1.0774

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(e)

Tutorial 8 Suggested Solutions

When funding a project with new equity, a firm might lose out on the
opportunity to further enhance the benefit of tax shield effect on debt.
Hence before deciding on the financing option, the company should
examine the trade-off between gain on tax shield and cost of financial
distress. However, in this case, West Central plc has already had a 40 to
60 split of debt and equity. Further increase in debt might not be
financially advantageous due to the potentially higher cost of financial
distress.
Apart from the trade-off effect, the company might also want to
consider the possible impact on its share price as a result of new equity
issue, i.e. the pecking order theory of finance. Event study evidence on
new security issues indicates 3% drop in share price, whereas risky debt
issues cause small price drops, which are not statistically different from
zero.

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Suggested Solution to FE2010 Zone B Question B5


(a)

Modigliani and Millers first proposition in a world with no taxes or


frictions implies that different capital structure does not affect the value
of a firm. Two firms with identical returns, regardless of their capital
structure, should have the same value.
Demonstration of MM capital structure irrelevance theorem is given as follows:

There are 2 firms:


o
An all-equity firm
==> Unlevered firm
o
A firm with B units of debt at the rate RD and the balance financed by
equity
==>Levered firm
An investor holds proportion of unlevered firms equity
The same investor also holds proportion of the levered firms equity and
proportion of the levered firms debt
Let X represents the firms cash flow
2 possible outcomes in a period ahead
o
Cash flow from firm X > face value of its debt B
o
Cash flow from firm X < face value of its debt B
Payoff for the investor under the 2 scenarios for both unlevered and levered
firms are as follows:

Debt
Equity
Total

Payoff for Unlevered Firm

!!!!!!!!!!"#$%&&!&%'!()*)')+!,-'.!!

X< B(1+RD)
0
X
X

X < B(1+ RD)


X
0
X

X> B(1+ RD)


0
X
X

X > B(1+ RD)


B(1+ RD)
[X - B(1+ RD)]
X

All investment income are the same


==> All investment should have the same value
==> Value of the firm is independent of its capital structure.

However, with the introduction of corporate tax, value of a firm is no


longer independent of its capital structure. Interest on debt is tax
deductible and hence a levered firm will increase its after tax cash flows
to investors. This implies that the higher the level of debt, the higher
the interest on debt, which attracts a higher tax saving. Hence, the value
of a levered firm is greater than the value of the unlevered firm by the
present value of the tax shield.
Firms should therefore gear up as much as possible to take advantage of
the tax shield.

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(b)

Debt is normally assumed to be relatively risk-free, hence with the tax


deductibility of its interest, gain on tax shield will add value to firm
with leverage. As the company continues to increase its debt, the cost
to finance the debt becomes higher as the debt is
now riskier to the
lender. The cost of financial distress will step in and subsequently
increase as a result. This implies a trade-off between the gain on tax
shield and cost of financial distress, causing an optimum capital
structure.

(c)

Tiger plc is currently operating at a loss, and will only become


profitable in three years time. This implies that it is unlikely that the
firm will be paying corporate income taxes. One might then argue
that the firm is effectively operating in a world without tax. Therefore,
Modigliani and Millers proposition on capital structure irrelevancy
theory applies and hence Tiger should be indifferent between equity
and debt finance.
From Year 4 to Year 8, Tiger starts making profits, hence it is more likely
that it will start paying corporate tax. With the benefit of tax shield,
Tiger should gear up as much as possible.
However, the firm has a substantial asset base which might already
have given the firm some significant investment credits. The firm
should choose an optimal level of debt which would take into
consideration other tax shield substitutes.
Beyond Year 8, Tiger seems to enjoy a steady growth. One might argue
that the potential cost of financial distress might be relatively low. The
firm should be able to afford a higher level of debt financing.
All in all, the firm might not need to wait until Year 8 to incorporate a
medium to high level of debt. If the management is confident about the
firms future, they might use a higher level of debt to signal the value of
the firm.

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Suggested Solution to FE2010 Zone Question B8


(a)

The signalling effect of debt on a firms value is emphasized by Ross


(1977). The intuition behind the Ross model is as follows. First of all,
firms are differentiated in terms of their quality, where quality is
essentially measured by the level of cashflow the firms can potentially
generate. Outsiders to the firm cannot observe a firms quality.
Managers of firms care about the firms value and hence the
management of high quality firms has an incentive to signal their
cashflow prospects to the market. If the market believes their signal,
then it will place a high value on these high quality firms. One way to
signal quality is to take on debt. Debt is a good signaling device as only
high quality firms can bear large interest payment burdens and are
willing to run the risk of bankruptcy. Hence, the signaling effect
implies that firms with large amounts of debt in their capital structure
should have high market values. (Please also show analytical derivation
of the results)
The argument in Ross (1977) is that debt is a costly signal due to the
possibility of bankruptcy it entails, and hence its use implies higherquality firms. The positive relationship of leverage and firm value is
supported by the empirical studies done by Masulis (1983), which
demonstrated that firms which swap debt for equity (thus increasing
leverage) experience positive stock price return and vice versa.

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Therefore, as the proportion of outstanding equity held by manager


increases with leverage, the manager chooses to supply more effort,
leading to increase in firm value. This implies that as leverage increases,
agency cost of outside equity decreases.

Graphical representation of the above relationship


Cost

Agency Cost of Equity

D/E

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However, when the face value of debt is low, the manager will choose
the low-risk, high-expected return project, leading to a higher value of
debt holders and equity holders. This implies that the lower the debt,
the higher the firm value. Graphically, the relationship can be shown as
follows:

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Cost

Agency Cost of Debt

D/E

From the diagram, the agency cost of debt increases with debt.
Combining these two agency costs will give rise to the total agency cost.
When total agency cost is at its minimum, value of firm is at its
maximum and optimal level of debt, or optimal capital structure of firm,
can be identified.
Cost

Total Cost

Cmin

Agency cost of
debt
0

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Agency cost of
equity

D/E*

D/E

25

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