Bond Covenants Encourage Managers To Play Games For Firms

Bond Covenants Encourage Game Playing By Managers For Firms In Financi

Bond covenants encourage game playing by managers for firms in financial distress True False Trade-off theory says the costs of financial distress offset some of debt's tax advantages True False The ability to use the interest tax shields impacts the debt decision True False In perfect capital markets, as the debt-equity (D/E) ratio drops, the return on equity falls and share price is unchanged True False Which of the following would you consider in determining your firm's capital structure A. Amount of business risk B. Ability to use tax shields C. Asset type (tangible, intangible) D. All of A, B, C E. None of A, B, C - only the cost of the securities is important In a world of perfect capital markets, firm value is maximized by A. Using all debt B. Capital structure is irrelevant C. Using all equit GM has a degree of financial leverage (DFL) of 2. If GM s EBIT decreases by 20%, then A. EPS will decrease by 40% B. EPS will increase by 40% C. EPS will increase by 10%. D. EPS will decrease by 10% Find the degree of financial leverage (DFL) if sales are 350,000; variable costs are $200,000; fixed costs are $80,000 and interest expense is 10,000. A. 1.17 B. 1.67 C. 2.14 D. 2.5 Your travels take you to a distant land with only one imperfection. Corporations must pay taxes, but the interest on debt is tax deductible. An unlevered firm has a value of $700,000. A similar firm is levered with $100,000 in debt. The return on debt is 6% and the debt is perpetual. Both are in a 30% tax bracket. What is the value of the levered firm A. 700,000 B. 730,000 C. 706,000 D. 800,000 Welcome to a world with perfect capital markets! A levered firm has 40% equity and 60% debt for its capital structure. With this capital structure, the firm has earnings per share of $3.60. This is a no growth firm (so all earnings are paid as dividends). The return on assets is 12%, and the return on debt is 8%. What is the share price? A. 20.00 B. 24.55 C. 18.00 D. 30.00

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Bond covenants are contractual agreements that restrict managerial actions in ways that can sometimes encourage gaming behavior, especially when firms are in financial distress. Managers may manipulate earnings or undertake riskier projects to meet debt covenants, which can lead to detrimental outcomes for stakeholders. The concept suggests that such covenants, while intended to protect creditors, may incentivize opportunistic behavior, highlighting a critical trade-off between risk mitigation and managerial flexibility.

The trade-off theory of capital structure posits that firms balance the benefits of debt—primarily the tax shield—against the costs of financial distress. Debt provides tax advantages because interest payments are tax-deductible, reducing the firm’s overall tax liability. However, higher leverage increases the risk of bankruptcy, which entails direct costs (legal, administrative) and indirect costs (loss of reputation, operational disruption). Firms seek an optimal capital structure where the marginal tax benefits of additional debt equal the marginal costs of financial distress.

The ability to utilize interest tax shields significantly impacts debt decisions because it effectively lowers the cost of debt funding. When firms can fully capitalize on the tax advantages of interest payments, they tend to favor debt financing to enhance value. Nonetheless, this decision is constrained by factors such as existing leverage levels, asset structure, and operational risks, which influence the firm's capacity to safely incorporate more debt into its capital structure.

In perfect capital markets—where there are no taxes, transaction costs, or informational asymmetries—themodification of capital structure has no effect on company value. According to Modigliani and Miller’s proposition, a firm’s value is determined solely by its underlying assets and not by its debt-equity mix. Consequently, whether a firm finances itself entirely with debt, equity, or a combination thereof does not influence its market value; the optimal capital structure becomes irrelevant under these ideal conditions.

GM’s degree of financial leverage (DFL) measures the sensitivity of earnings per share (EPS) to changes in operating income (EBIT). With a DFL of 2, a 20% decrease in EBIT will double the percentage change in EPS, leading to a 40% decline in EPS. This illustrates how leverage magnifies the impact of operational fluctuations on shareholder earnings, emphasizing the risk-return trade-off associated with debt financing.

Calculating the degree of financial leverage (DFL) involves analyzing the firm's contribution margin, fixed costs, and interest expenses. Given sales of $350,000, variable costs of $200,000, fixed costs of $80,000, and interest of $10,000, the DFL can be computed by evaluating the proportionate effect of EBIT fluctuations on EPS. A DFL of approximately 1.67 indicates moderate leverage, reflecting the interplay of operating and financial expenses on profitability.

The value of a levered firm can be derived using the Modigliani-Miller theorem with corporate taxes. Starting with the unlevered value of $700,000, the tax shield from debt ($100,000 at 6% with a 30% tax rate) adds to the firm's value. Therefore, the levered firm’s value becomes approximately $730,000, considering the tax deductibility of debt interest, illustrating how debt can enhance firm value when tax shields are fully utilized.

In a perfect capital market scenario, the value of a levered firm with $100,000 debt and a tax rate of 30% is computed by adding the present value of the tax shield to the unlevered firm’s value. This results in a total firm value of around $730,000. This demonstrates the importance of tax considerations in capital structure decisions, although such market imperfections in real-world scenarios often complicate this simplification.

Finally, calculating the share price of a firm with a given capital structure and earnings involves applying the dividend discount model or valuation multiples. With a 40% equity stake and earnings per share (EPS) of $3.60, the share price is found to be approximately $24.55, assuming a no-growth scenario and a return on assets of 12%. This valuation reflects market expectations of earnings and risk associated with the company's capital structure.

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