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    AI2246 - Corporate Finance

    • Exam 20-03-09 → E-C Questions
    • Multiple Choice Questions 1-8 (8p)
    • 9. Carefully Explain the following terms (6p)
    • 🤙 10. Calculate the yield to maturity of a semi annual bond (6p)
    • 11. Calculate the marginal corporate tax (10p)
    • C1. Valuing a amortising firm with flow to equity and WACC method
    • 🌸 C2. Perfect Capital Markets
    • E & C Questions - Exam 2022-03-16
    • 🍭1. Yield to Maturity (YTM) - Five year corporate bond
    • 2. Balance a balance sheet after selling shares to raise cash to pay off debt
    • 🌻 3. Calculate Return on Equity and WACC given 4 inputs
    • 4. Calculate Annual Tax Shield on 500 MSEK of Debt amoritized over 20 years
    • 5. Calculate the firm value, constant debt-to-value ratio and using the WACC Method
    • 🐝 6C. The stupidity of using WACC or FTE to value a amortising firm
    • 🐘 7C. Calculate a new required rate of return given a new capital structure
    • Misc Questions that I think are good, but have not yet answered
    • C-Questions - 2. Explain how financial distress affects new positive-NPV investments
    • A8. Calculate

    Formats

    E-Questions are blue

    C-Questions are Yellow

    A-Questions are red

    Emojis for questions that you learn a lot from 🧠

    Exam 20-03-09 → E-C Questions

    Multiple Choice Questions 1-8 (8p)

    1. Which of the following statements is CORRECT?

      2. a) The volatility of the price of a bond is not affected by its time to maturity.

      b) The yield curve for a particular bond shows the bond’s sensitivity to interest rate changes.

      c) The yield curve is most often upward sloping.

      d) Real interest rates can never be negative.

      ‣
      Solution ✅ 
      ✅
      c) The yield curve is most often upward sloping.
      image
    2. Which of the following statements is FALSE?

      3. a) At maturity the price of a bond equals the face value minus the sum of all coupon payments.

      b) The yield to maturity of a bond is affected by the coupon rate as well as the timing of the coupon payments.

      c) A default‐free zero coupon bond that matures one year from now provides a risk‐free return over that period.

      d) The price of a bond equals the present value of all future coupon payments plus the present value of the face value.

      ‣
      Solution ✅

      a) At maturity the price of a bond equals the face value minus the sum of all coupon payments. ✅

      🧠
      At maturity, we only get the face value of the bond, since the coupon payments have already been paid to the bond holder.
    3. Which of the following statements is CORRECT?

      4. a) In a perfect capital market the value of a firm is not dependent on the risk of its expected cash‐flow.

      b) In a market with imperfections the value of a firm is not dependent on the risk of its expected cash‐flow.

      c) In a perfect capital market the WACC of an unlevered firm equals the WACC of the same firm if it was 50 percent equity financed.

      d) In a perfect capital market the required rate of return on debt is not dependent of the firm’s capital structure.

      ‣
      Solution ✅

      c) In a perfect capital market the WACC of an unlevered firm equals the WACC of the same firm if it was 50 percent equity financed. ✅

      🧠
      In a perfect capital market, the Weighted Average Cost of Capital (WACC) of a firm is determined solely by its risk, as reflected in its required rate of return. If the firm is unlevered, its WACC would be equal to the WACC of the same firm if it was 50 percent equity financed, assuming the market is perfect and the risk of the firm remains constant.
    4. Which of the following statements is CORRECT?

      5. a) Tax at personal investor level does not affect the value of interest tax‐shield for a firm.

      b) The majority of stock owners prefer levered firms since the expected return on equity is higher than for unlevered firms.

      c) The value of a levered firm (with debt and equity securities only) may be lower or higher than the sum of the value of the debt and the value of the equity.

      d) If corporate tax is the only market imperfection, the increase in value of an unlevered firm that takes on debt equals the present value of all future expected tax shields.

      ‣
      Solution ✅

      c) The value of a levered firm (with debt and equity securities only) may be lower or higher than the sum of the value of the debt and the value of the equity. ✅

      🧠
      The value of a levered firm can be lower or higher than the sum of the value of its debt and the value of its equity because the use of debt financing can both increase and decrease the value of a firm, depending on the specific circumstances. For example, the tax benefits of debt financing can increase the value of a firm, while the increased financial risk associated with debt financing can decrease its value. The ultimate impact of debt financing on a firm's value will depend on the interplay of various factors, such as the firm's risk, the cost of debt, and the tax benefits of debt financing.
    5. Which of the following statements is FALSE?

      6. a) Because the cash flows promised by the bond are the most that bondholders can hope to receive, the cash flows that a buyer of a bond with credit risk expects to receive may be less than that amount.

      b) By consulting bond ratings, investors can assess the credit‐worthiness of a particular bond issue.

      c) Because the yield to maturity for a bond is calculated using the promised cash flows, the yield of bond’s with credit risk will be lower than that of otherwise identical default‐free bonds.

      e) A higher yield to maturity does not necessarily imply that a bond's expected return is higher.

      ‣
      Solution (2p) ✅

      c) Because the yield to maturity for a bond is calculated using the promised cash flows, the yield of bonds with credit risk will be lower than that of otherwise identical default-free bonds. ✅

      🧠
      This statement is false. In general, bonds with higher credit risk will have a higher yield to maturity compared to otherwise identical default-free bonds. The yield to maturity of a bond with credit risk will be higher than that of a default-free bond to reflect the higher risk of default associated with the bond.
    6. Consider a bond with three years to maturity that pays a coupon of 12 at the end of each year. The face value is 80 and the price of the bond is 80. The yield to maturity is closest to:

      7. a) 11%

      b) 13%

      c) 15%

      d) 17%

      ‣
      Solution ✅

      c) 15%

      ✅
      Answer → c) 15% Yield to Maturity = (Annual Interest + ((Face Value - Price)/ (Time to Maturity)) / ( (Face value + Price ) / 2) YTM = (12 + (80-80)/3)) / (80+80/2) = 12/80 = 0,15
      🧠
      The yield to maturity of a bond is the rate of return an investor would receive if they bought the bond at its current market price and held it until it matured. Yield to Maturity = [Annual Interest + {(FV-Price)/Maturity}] / [(FV+Price)/2]

    7. Which of the following statements is FALSE?

    a) In perfect capital markets, investors are indifferent between the firm distributing funds via dividends or share repurchase.

    b) The tax rates on dividends and capital gains affect the choice between paying dividends or repurchasing shares.

    c) In perfect capital markets, holding fixed the investment policy of a firm, the firm’s choice of dividend policy is irrelevant.

    d) In perfect capital markets, dividend payment will not affect the value of a firm.

    ‣
    Solution (2p) ✅
    ☝
    FALSE → d) In perfect capital markets, dividend payment will not affect the value of a firm.
    🧠
    Dividends is money earned by the firm, paid out as profit to shareholders → Money leaves the balance sheet in this transaction which in turn effects the value of the firm.
    1. Which of the following statements is CORRECT?

      2. a) The details of a corporate bond offering can be found in the prospectus.

      b) A senior bond issue is an offering aimed at elderly people.

      c) The details of a credit rating can be found in a bond covenant.

      d) None of the above alternatives.

      ‣
      Solution ✅

      a) The details of a corporate bond offering can be found in the prospectus.

    9. Carefully Explain the following terms (6p)

    a) Weighted average cost of capital (2p)

    b) Financial Distress (2p)

    c) Yield to maturity (2p)

    ‣
    a) Weighted average cost of capital ✅
    🧠
    WACC is the average rate at which a company expects to finance its assets AND a common way to determine the required rate of return (RRR or discount rate). In a single number it expresses the return that both bondholders and shareholders demand to provide the company with capital.
    Pre-Tax WACC=ED+Ere+DD+Erd\text{Pre-Tax WACC} = \frac{E}{D+E}r_e + \frac{D}{D+E}r_dPre-Tax WACC=D+EE​re​+D+ED​rd​WACC=ED+Ere+DD+Erd(1−tax)\text{WACC} = \frac{E}{D+E}r_e + \frac{D}{D+E}r_d(1-tax)WACC=D+EE​re​+D+ED​rd​(1−tax)
    • WACC is the weighted discount rate or rate of return of the company in question.
    • WACC takes into account both equity and debt, and their respective cost of capital.
    • Pre-tax WACC does not take into account tax-shields created by tax deductable interest rates.
    ‣
    b) Financial Distress ✅
    ✅
    A common term in corporate finance, mainly used when company's financial condition leaves them struggling to pay their bills, especially loan payments due to creditors eg. the company is financed with debt. Basically, income flows fail to meet the required spending outflows owed to outstanding obligations of the company. For example, a run on the bank can cause financial distress causing the bank to sell assets at a discount to meet the outflows of people withdrawing their money. There is a trade of when you finance anything with debt, financial distress is mainly caused by lending and then not beeing able to finance the debt.
    ‣
    c) Yield to maturity ✅
    ✅
    Yield to maturity (YTM) is the total rate of return that will have been earned by a bond when it makes all interest payments and repays the original principal. Yield to maturity is equivalent with Internal Rate of Return (IRR) but for bonds.
    Price of Bond =CF1(1+YTM)n+CF2(1+YTM)n+FV(1+YTM)n+\text{Price of Bond } = \frac{CF_1}{(1+YTM)^n}+\frac{CF_2}{(1+YTM)^n}+\frac{FV}{(1+YTM)^n}+Price of Bond =(1+YTM)nCF1​​+(1+YTM)nCF2​​+(1+YTM)nFV​+
    image

    🤙 10. Calculate the yield to maturity of a semi annual bond (6p)

    A bond that matures in two years pays semiannual coupons. The first coupon payment is 6 months from now. The face value of the bonds is 100 MSEK and the coupon rate is 5%. The price of the bond is 93 MSEK. What is the yield to maturity?
    ‣
    Solution ✅
    1️⃣
    Step 1. Figure out your inputs
    Face Value
    100 MSEK
    Coupon Rate
    5%
    Years to Maturity
    2 Years
    Coupon Payment
    Semi-Annual
    Payment Periods
    4
    Price (PV)
    93 MSEK
    image
    2️⃣
    Step 2. Calculate Semi-Annual Coupon Rate on Bond Semi-Annual Coupon Rate (%) = (5.0%)/2 = 2.5%
    3️⃣
    Step 3. Calculate the Semi-Annual Coupon Payment on Bond Semi-Annual Coupon (C) = 2.5% x 100 = 2,5 MSEK
    4️⃣
    Step 4. Calculate Yield to Maturity Calculation Example Semi-Annual Yield to Maturity = [2.5 + (100 – 93) / 4] / [(100+93) / 2] Semi-Annual Yield to Maturity = 0.0440 → 4,4%
    5️⃣
    Step 5. Convert Semi-annual yield to maturity to Annual Yield To Maturity Annual Yield to Maturity (YTM) = 4.4% × 2 = 8.8%

    11. Calculate the marginal corporate tax (10p)

    The current debt‐to‐equity ratio for Prime Properties is 2.5. The interest rate on debt is 5% and the required rate of return for an unlevered firm with assets identical to those owned by Prime Properties is 6.5%. The after‐tax WACC for Prime Properties is 5.75%. What is the marginal corporate tax rate?

    ‣
    Solution ✅
    1️⃣
    Figure out inputs
    D/E
    2,5
    Interest on debt (rd)
    5%
    Return Value (ru)
    6,5%
    Return Equity (re)
    ???
    After Tax WACC (wacc)
    5,75%
    Corporate Tax (tc)
    ???

    Step 1. Calculate re with this formula (Return on equity = re) re = ru + D/E(ru-rd) re = 0,065 + 2,5*(0,065-0,05) re= 0,065 + 0,0375 = 0,1025 re = 10,25%

    2️⃣
    Step 2. Calculate Debt to equity D/E = 2,5 → D = 2,5E D + E = 3,5E Which gives: D/(E+D) = 2,5/3,5 E/(E+D) = 1/3,5
    3️⃣
    Step 3. The marginal corporate tax rate with the WACC formula WACC = E/(D+E)*re + D/(E+D)*rd(1-tc) 0,0575 = (1/3,5)*0,1025 + (2,5/3,5)*0,05*(1-tc) 0,0575 = (0,0292)+ (0,0357)*(1-tc) 0,0575 = 0,0649 - 0,0357*tc -0,0074 = - 0,0357*tc → tc = 0,0074/0,0357 tc = 0.207 → 21% The marginal Corp Tax Rate is approx 21%

    C1. Valuing a amortising firm with flow to equity and WACC method

    Explain thoroughly why the WACC method and the Flow-to-equity method are not suitable for valuing a firm when the firm’s debt will be fully amortised over the next five years and how you should value the firm in this scenario.
    ‣
    Answer ✅
    1️⃣
    First Problem - Caused by the Loan To Value Ratio Amortising debt over a five year period means that the firms Loan To Value (LTV) ratio is not constant during the valuation period. To utlilize either the WACC method or the Flow to equity method, we would have to calculate a new WACC and Return on equity for each year, making the calculation more complex than other methods.
    2️⃣
    Second Issue - How the methods discount future values WACC Since WACC = The discount rate we use to calculate PV of the asset. Flow to Equity and since Return on equity = The discount rate we use to calculate PV of the asset.
    3️⃣
    Proposed Solution - Adjusted Present Value Method (APV) APV = (Unlevered Firm Value) + (Present Value Tax Shield) This method discounts the cashflows with it’s unlevered required rate of return, then you add the present value of the taxshield caused by interest payments.

    🌸 C2. Perfect Capital Markets

    Logistic Properties (LP) is a property company with a current share price of 6 SEK and 20 million shares outstanding. Suppose LP announces plans to lower its corporate taxes by borrowing 80 MSEK.

    a) With perfect capital markets, what will the share price be after this announcement? (2p)

    Suppose that LP pays a corporate tax rate of 25%, and that shareholders expect the change in debt to be permanent.

    b) If the only imperfection is corporate taxes, what will the share price be after this announcement? (4p)

    c) Suppose the only imperfections are corporate taxes and financial distress costs. If the share price rises to 6.5 SEK after this announcement, what is the PV of financial distress costs LP will incur as the result of this new debt? (If you have not been able to calculate the share price in question b) you may denote the answer to b) with an X.) (4p)

    ‣
    a) What happens to the stock price? ✅
    ✅
    The stock price will be unchanged, meaning it will still be 6 SEK per share.
    🧠
    Explain why? Assuming perfect capital markets, all investors have the same access to information and the same investment opportunities, there are no transaction costs or taxes, and there are no restrictions on borrowing or lending money. In such a market, investors can borrow or lend money at the same risk-free rate, and the value of a firm is based on its expected future cash flows, which are independent of its financing decisions.
    ‣
    b) The only imperfection is corporate taxes, what is the new share price? ✅
    1️⃣
    Step 1. Calculate the Permanent Tax Shield Tax Shield = (Corporate Taxes) * Debt Tax Shield = 0,25*80 MSEK → 20 MSEK
    2️⃣
    Step 2. Calculate the current value of the firm Firm Value = (Number of shares) * (Share Price) Firm Value = 20 000 000 * 6 SEK → 120 MSEK
    3️⃣
    Step 3. Calculate the new firm Value New Firm Value = (Firm Value + Tax Shield) / (Number of shares) New Firm Value = (120 MSEK + 20 MSEK) / (20 Milj. Shares) → 140 / 20 = 7 SEK per share
    ✅
    The new share price is 7 SEK per share
    ‣
    c) What is the financial distress costs? ✅
    🧠
    We asserted the new firm value and share price to 7 SEK per share. Real Value - Current Share Price → 7 - 6,5 = 0,5 Financial Distress Costs = 0,5*(Tax Shield) → 0,5*20 MSEK = 10 MSEK Answer: The current cost of the financial distress caused by the new debt is 10 MSEK.

    E & C Questions - Exam 2022-03-16

    🍭1. Yield to Maturity (YTM) - Five year corporate bond

    Consider a five-year corporate bond with a face value of 1100 SEK and with a 7% coupon rate paid as annual coupons. What is the yield to maturity of the bond if the price today is 985 SEK?
    ‣
    Solution ✅
    1️⃣
    Figure out inputs
    Face Value (FV)
    1100
    Coupon Rate (C)
    7%
    Years To Maturity
    5
    Present Value (PV)
    985 SEK
    Periods (n)
    5
    Yield to Maturity (YTM) =C+FV−PVnFV+PV2\text{Yield to Maturity (YTM) } = \frac{C + \frac{FV-PV}{n}}{\frac{FV+PV}{2}}Yield to Maturity (YTM) =2FV+PV​C+nFV−PV​​

    Formula for YTM C = 7% * Face Value → 1100*7% = 77

    ✅
    2. Use formula for answer YTM = (77 + (115/5))/(2085/2) YTM = 0,0959 → 9,6%

    2. Balance a balance sheet after selling shares to raise cash to pay off debt

    Large City Properties (LCP) has the following market value balance sheet:
    Assets
    Liabilities
    Cash
    10 MSEK
    30 MSEK
    Debt
    Real Assets
    80 MSEK
    60 MSEK
    Equity
    Sum Balance Sheet
    90 MSEK
    90 MSEK

    LCP has decided to raise 15 MSEK in cash by selling new shares. The cash will be used to amortize 15 MSEK of the debt. Show what the market value balance sheet will look like after the debt has been amortized assuming that Modigliani-Miller’s proposition 1 holds true.

    ‣
    Solution ✅

    ✋⚠️ Note this could be a two step solution, where you add 15 MSEK to the cash balance when the equity is sold, then in the final step (shown below) amortise 15 MSEK of debt.

    Assets
    Liabilities
    Cash
    10 MSEK
    15 MSEK
    Debt
    Real Assets
    80 MSEK
    75 MSEK
    Equity
    Sum Balance Sheet
    90 MSEK
    90 MSEK

    🌻 3. Calculate Return on Equity and WACC given 4 inputs

    The current debt-to-equity ratio for Prime Properties is 2. The interest rate on debt is 6% and the required rate of return for an unlevered firm with assets identical to those owned by Prime Properties is 9%. What is the after-tax WACC if the marginal corporate tax rate is 25%?
    ‣
    Solution ✅
    1️⃣
    Step 1. Figure out inputs
    D/E
    2
    Interest Rate Debt (rd)
    6%
    Return Unlevered Firm (ru)
    9%
    Return on equity (re)
    ???
    Corp Tax (tc)
    25%
    WACC
    ???
    2️⃣
    Step 2. Calculate Return on Equity re = ru + (D/E)*(ru-rd) re = 0,09 + 2*(0,09-0,06) re = 0,09 + 0,06 re = 15% or 0,15
    3️⃣
    Step 3. Calculate Debt to Equity Ratio D/E = 2 → D = 2E D+E = 3 D = 2 E = 1
    3️⃣
    Step 4. Calculate the WACC WACC = E/(D+E)*re + D/(E+D)*rd(1-tc) WACC = 1/3*0,15 + 2/3*0,06*(1-0,25) WACC = 0,08 → 8% ✅

    4. Calculate Annual Tax Shield on 500 MSEK of Debt amoritized over 20 years

    City Limit Properties (CLP) has just borrowed 500 MSEK that will be amortized with an equal amount over 20 years. The interest, paid in the end of each year, is 5%. What is value of the tax-shield that this financing arrangement provides assuming that the corporate tax-rate is 25%? For this question, assume one would like to know the annual taxshield caused by the debt.
    ‣
    Solution ✅
    1️⃣
    Step 1. Figure out Inputs
    Debt (D)
    500 MSEK
    Periods / Years
    20
    Yearly Amortisation
    500/20 = 25MSEK
    Interest Rate (rd)
    5%
    Corp Tax Rate (Tc)
    25%
    2️⃣
    Step 2. Caculate the Annual Tax Shield Tax Shield = Tc*rd*D Annual Tax Shield = (0,25*0,05*500)/20 = 0,3125 MSEK ✅ You can also calculate is this way, as our professor does in his solution. Tax shield = 0,25*0,05*25MSEK = 0,3125 MSEK

    5. Calculate the firm value, constant debt-to-value ratio and using the WACC Method

    Following is a 3-year forecast of the cash flows from the properties of a property firm:
    Year
    1
    2
    3
    Rent
    Operating Cost
    NOI
    Marginal corporate tax rate:
    25%
    Debt-to-value ratio of the firm:
    70%
    Interest rate on the debt
    7.0%
    Pre-tax WACC for the firm
    11%
    Perpetual growth rate of NOI from the end of year three:
    1.0%

    Calculate the firm value assuming a constant debt-to-value ratio and using the Weighted Average Cost of Capital (WACC) method.

    ⚠️
    This question was used during a Covid Exam where students had access to excel. This is horrible to calculate by hand. Hence I’ve excluded it from here this solution.

    🐝 6C. The stupidity of using WACC or FTE to value a amortising firm

    A firm currently has a debt-to-value ratio of 60%. Explain carefully why the WACC method and the Flow-to-equity method are not suitable for valuing the firm when the firm’s debt will be fully amortized over the next five years and what would be a better method to value the firm in this scenario assuming that the only market imperfection is corporate taxes. (7.5p)
    ‣
    Answer ✅
    1️⃣
    Flow to Equity or FTE-Method Equity is discounted by return on equity (eg. Cashflow that reaches shareholders is discounted by return on equity in a levered scenario.) Weighted Average Cost of Capital or WACC-Method Free Cash-flow is discounted by Return on WACC. Both methods are based on the D-to-E ratio, which will change when you amortise. Return Equity (re)=ru+DE(ru−rd)\text{Return Equity } (r_e) = r_u + \frac{D}{E}(r_u-r_d)Return Equity (re​)=ru​+ED​(ru​−rd​)Return WACC=EE+Dre+DE+Drd(1−Tc)\text{Return WACC} = \frac{E}{E+D}r_e+\frac{D}{E+D}r_d(1-T_c)Return WACC=E+DE​re​+E+DD​rd​(1−Tc​)
    2️⃣
    The Problem with these methods when amortizing debt Both methods calculates a discount rate that is based on a debt-to-equity ratio. Paying of debt would lead to a new discount rate for each subsequent year, unless the firm sell new shares at the same pace. (Which is a stupid assumption)
    🧠
    Proposed Solution - Adjusted Present Value Method (APV) This method discounts the cashflows with the unlevered discount rate, which is not derived from a D-to-E ratio. Then the present value of tax shields are discounted by the cost of capital (rd). Meaning, getting APV = (Unlevered Firm Value) + (Present Value Tax Shield)

    🐘 7C. Calculate a new required rate of return given a new capital structure

    The current debt-to-equity ratio for CBD Properties is 1.5. The required rate of return on debt is 5%. The after-tax WACC for CBD Properties is 6.65%. The marginal corporate tax rate is 25%. Assume that CBD Properties wants to change its capital structure so that the debt-to-value ratio equals 0.8. At this debt-to-value ratio the required rate of return on debt is 6%. Assuming perfect capital markets, what is the required rate of return on the firm’s equity at the new debt-to-value ratio?
    ‣
    Answer ✅
    D/E
    1,5
    Return Debt (rd)
    5%
    Old Return on equity (re)
    ???
    After tax Wacc (WACC)
    6,65%
    Tax Rate (tc)
    25%
    New Return on debt (rdn)
    6%
    New Debt to value ratio (D/E+D)
    0,8
    New Return on equity (ren)
    ???
    1️⃣
    Step 1. Calculate “old” Debt to equity ratios D/E = 1,5 → D = 1,5 E E = 1 D = 1,5 Debt to value ratio: D/ (E+D) = 1,5/2,5 = 0,6 Equity to value ratio: E / (E+D) = 1/2,5 = 0,4
    2️⃣
    Step 2. Calculate Old return on equity (re) WACC = E/(D+E)*re + D/(E+D)*rd(1-tc) 0,0665 = re*0,4 + 0,05*0,6*(1-0,25) 0,044 = re*0,4 re = 0,11 → Old re = 11%
    3️⃣
    Step 3. Calculate an unlevered return based on the old numbers ru = E/(D+E)*re + D/(E+D)*rd ru = 0,4*0,11 + 0,6*0,05 ru = 0,074 → Return unlevered firm = 7,4%
    4️⃣
    Step 4. Use the ru to calculate the new return on equity (ren) New debt to equity ratios Dnew/(Dnew+Enew) = 0,8 → New D/E = 4 New re(n) = ru + (New D/E)*(ru-rdn) → (rdn = New return on debt, given by the question.) New re(n) = 7,4% + 4*(7,4%-6%) → New return on equity = 0,074 + 4*(0,014) → 0,13 New return on equity = 13% ✅

    Misc Questions that I think are good, but have not yet answered

    C-Questions - 2. Explain how financial distress affects new positive-NPV investments

    Explain thoroughly why it may not be in the interest of shareholders of a firm that faces financial distress to finance new positive-NPV investments.
    🧠
    What is financial distress? A financial condition leaves the company struggling to pay their bills, especially loan payments due to creditors eg. the company is financed with debt. Basically, income flows fail to meet the required spending outflows, owed to outstanding obligations of the company.

    A8. Calculate

    Coworking Space (CS) is a 100% equity financed property company with a current share price of 5 SEK and 25 million shares outstanding. Suppose CS announces plans to lower its corporate tax payments by borrowing 70 MSEK. The debt will be constant in perpetuity. Suppose the only market imperfections are corporate taxes and financial distress costs. If the share price rises to 5.25 SEK after this announcement, what is the present value of financial distress costs that are incured as a result of this new debt? The marginal corporate tax rate is 30%. (5p) (from 2022-03 exam)

    Re-Exam 2022

    C-Questions

    Explain carefully the trade-off theory of capital structure including the effects of agency costs and agency benefits. (7.5p)
    The Trade-Off Theory of Corporate Capital Structure

    "The Trade-Off Theory of Corporate Capital Structure" published on by Oxford University Press.

    oxfordre.com

    Trade-off theory of capital structure

    The trade-off theory of capital structure is the idea that a company chooses how much debt finance and how much equity finance to use by balancing the costs and benefits. The classical version of the hypothesis goes back to Kraus and Litzenberger who considered a balance between the dead-weight costs of bankruptcy and the tax saving benefits of debt. Often agency costs are also included in the balance. This theory is often set up as a competitor theory to the pecking order theory of capital structure. A review of the trade-off theory and its supporting evidence is provided by Ai, Frank, and Sanati.

    en.wikipedia.org

    Trade-off theory of capital structure