Podcast
Questions and Answers
According to Miller's (1977) model, which statement about personal taxes is most accurate?
According to Miller's (1977) model, which statement about personal taxes is most accurate?
- Personal taxes can influence the tax benefits of debt and must be considered. (correct)
- Personal taxes should be ignored when determining a firm's leverage.
- Personal taxes have no effect on a firm's optimal capital structure.
- Personal taxes increase the tax benefits of debt unrealistically assumed in MM2.
In the context of the Miller (1977) model, how do tax-exempt investors typically behave in relation to firm leverage?
In the context of the Miller (1977) model, how do tax-exempt investors typically behave in relation to firm leverage?
- They prefer firms with high leverage. (correct)
- They prefer firms with low leverage.
- They are indifferent to the level of firm leverage.
- They avoid investing in firms with any debt.
How do taxes on dividends, capital gains, and interest income typically compare?
How do taxes on dividends, capital gains, and interest income typically compare?
- Taxes on interest income are always lower.
- They're equivalent regardless of jurisdiction.
- They are not equivalent and vary by jurisdiction. (correct)
- Taxes on dividends, capital gains and interest income are the same.
In Miller's (1977) model, what is implied when $t_D = t_E$ (where $t_D$ is the personal tax rate on debt and $t_E$ the tax rate on equity)?
In Miller's (1977) model, what is implied when $t_D = t_E$ (where $t_D$ is the personal tax rate on debt and $t_E$ the tax rate on equity)?
In the context of corporate tax rates in France (2023), what is the standard corporate tax rate?
In the context of corporate tax rates in France (2023), what is the standard corporate tax rate?
In France (2023), what is the tax rate applied to capital gains for individuals, excluding any income tax considerations?
In France (2023), what is the tax rate applied to capital gains for individuals, excluding any income tax considerations?
Under what condition can the reduced corporate tax rate of 15% be applied in France (2023)?
Under what condition can the reduced corporate tax rate of 15% be applied in France (2023)?
What is a key implication of the Miller model regarding the impact of debt on firm value, contrasting it with Modigliani-Miller's original theory?
What is a key implication of the Miller model regarding the impact of debt on firm value, contrasting it with Modigliani-Miller's original theory?
What is the formula to calculate the value of a levered firm (VL) according to Miller's model, considering the value of an unlevered firm (VU), corporate tax rate (T), personal tax rate on equity ($t_E$), and personal tax rate on debt ($t_D$)?
What is the formula to calculate the value of a levered firm (VL) according to Miller's model, considering the value of an unlevered firm (VU), corporate tax rate (T), personal tax rate on equity ($t_E$), and personal tax rate on debt ($t_D$)?
What factor primarily determines the risk-free rate used to discount the cash flows associated with the debt tax shield in Miller's model?
What factor primarily determines the risk-free rate used to discount the cash flows associated with the debt tax shield in Miller's model?
Which of the following statements is true regarding bankruptcy costs and capital structure?
Which of the following statements is true regarding bankruptcy costs and capital structure?
What distinguishes direct costs of bankruptcy from indirect costs?
What distinguishes direct costs of bankruptcy from indirect costs?
Which of the following increases the likelihood a company will have less debt according to research?
Which of the following increases the likelihood a company will have less debt according to research?
What does Standard & Poor's consider when assigning a corporate credit rating?
What does Standard & Poor's consider when assigning a corporate credit rating?
What factors are considered in Industry Risk when determining a corporate rating?
What factors are considered in Industry Risk when determining a corporate rating?
What factors are considered in Financial Risk when determining a corporate rating?
What factors are considered in Financial Risk when determining a corporate rating?
In the event of a corporate liquidation in France, which of the following creditors has the highest priority?
In the event of a corporate liquidation in France, which of the following creditors has the highest priority?
What is the primary goal of Chapter 7 bankruptcy under the U.S. Bankruptcy Code?
What is the primary goal of Chapter 7 bankruptcy under the U.S. Bankruptcy Code?
What is the main feature of Chapter 11 bankruptcy proceedings?
What is the main feature of Chapter 11 bankruptcy proceedings?
Consider a firm with potential bankruptcy costs. The firm's value is calculated as VL = VU + PV(tax shield) – PV of E(bankruptcy costs). How does an increase in expected(E) bankruptcy costs affect the firm's optimal capital structure?
Consider a firm with potential bankruptcy costs. The firm's value is calculated as VL = VU + PV(tax shield) – PV of E(bankruptcy costs). How does an increase in expected(E) bankruptcy costs affect the firm's optimal capital structure?
A company has Earnings Before Interest and Taxes (EBIT) of $500,000 and interest expenses of $100,000. What is the interest coverage ratio, and what does a lower ratio typically indicate?
A company has Earnings Before Interest and Taxes (EBIT) of $500,000 and interest expenses of $100,000. What is the interest coverage ratio, and what does a lower ratio typically indicate?
Why might firms with stable and predictable cash flows be able to take on more debt than firms with more volatile cash flows?
Why might firms with stable and predictable cash flows be able to take on more debt than firms with more volatile cash flows?
In a situation of a credit ratings downgrade, what effect would that have on interest rate?
In a situation of a credit ratings downgrade, what effect would that have on interest rate?
According to the content provided, which is the best description of the correlation between ratings and default risk?
According to the content provided, which is the best description of the correlation between ratings and default risk?
If investors are subject to taxation, which firms do they prefer to invest in and why?
If investors are subject to taxation, which firms do they prefer to invest in and why?
According to the content, what distinguishes the value of a levered firm (VL) under Miller’s model versus the Modigliani-Miller model (MM) when considering personal taxes?
According to the content, what distinguishes the value of a levered firm (VL) under Miller’s model versus the Modigliani-Miller model (MM) when considering personal taxes?
A firm is considering increasing its debt level. How do corporate and personal taxes affect its decision, according to Miller's model?
A firm is considering increasing its debt level. How do corporate and personal taxes affect its decision, according to Miller's model?
If a firm's debt rating falls from A to BBB, what is the most likely consequence regarding its cost of borrowing?
If a firm's debt rating falls from A to BBB, what is the most likely consequence regarding its cost of borrowing?
Which costs are typically higher, direct or indirect bankruptcy costs?
Which costs are typically higher, direct or indirect bankruptcy costs?
How does the level of industry risk typically impact a company's decision to use debt financing?
How does the level of industry risk typically impact a company's decision to use debt financing?
Why do tax-exempt investors typically prefer investing in firms with high leverage?
Why do tax-exempt investors typically prefer investing in firms with high leverage?
Which of the following statements is most accurate, according to the context provided?
Which of the following statements is most accurate, according to the context provided?
According to the Capital Structure section, does firm leverage impact firm value under the presence of personal taxes?
According to the Capital Structure section, does firm leverage impact firm value under the presence of personal taxes?
What is the most common range observed for the bankruptcy costs of a firm?
What is the most common range observed for the bankruptcy costs of a firm?
When determining a company's rating, which metric can be used to determine safety?
When determining a company's rating, which metric can be used to determine safety?
How are creditors typically paid during liquidation?
How are creditors typically paid during liquidation?
A company is considering a capital structure adjustment and wants to understand its synthetic credit spread. Given an interest coverage ratio is 2.1, what rating is appropriate?
A company is considering a capital structure adjustment and wants to understand its synthetic credit spread. Given an interest coverage ratio is 2.1, what rating is appropriate?
Other than a company’s financial metrics, what are some other factors that credit agencies factor into a credit rating?
Other than a company’s financial metrics, what are some other factors that credit agencies factor into a credit rating?
A distressed firm experiencing losses of customers and suppliers is facing what costs?
A distressed firm experiencing losses of customers and suppliers is facing what costs?
A country is considered too risky for a company to have operations there. What type of risk does this apply to?
A country is considered too risky for a company to have operations there. What type of risk does this apply to?
The interest coverage ratio is 2.5. According to the context what ratings agency ratings does this correspond to?
The interest coverage ratio is 2.5. According to the context what ratings agency ratings does this correspond to?
A firm has a high probability of bankruptcy, how will that impact debt financing?
A firm has a high probability of bankruptcy, how will that impact debt financing?
Under Miller's (1977) model, how does the effective tax advantage of debt change when personal taxes are considered, compared to when they are ignored?
Under Miller's (1977) model, how does the effective tax advantage of debt change when personal taxes are considered, compared to when they are ignored?
According to the content given, how does the presence of personal taxes impact investment preferences for investors subject to taxation versus tax-exempt investors?
According to the content given, how does the presence of personal taxes impact investment preferences for investors subject to taxation versus tax-exempt investors?
In the context of the Miller (1977) model, which condition would lead to a scenario most closely resembling the Modigliani-Miller (MM2) model with corporate taxes but without personal taxes?
In the context of the Miller (1977) model, which condition would lead to a scenario most closely resembling the Modigliani-Miller (MM2) model with corporate taxes but without personal taxes?
In France (2023), a company is eligible for the reduced corporate tax rate of 15%. However, its profits exceed €42,500. What corporate tax rate will apply to the portion of profits exceeding this threshold?
In France (2023), a company is eligible for the reduced corporate tax rate of 15%. However, its profits exceed €42,500. What corporate tax rate will apply to the portion of profits exceeding this threshold?
A company in France has a marginal tax rate of 30% for its individual investors. When assessing the dividend tax, which rate would they likely choose, considering the withholding tax option?
A company in France has a marginal tax rate of 30% for its individual investors. When assessing the dividend tax, which rate would they likely choose, considering the withholding tax option?
According to the information, how would a credit rating agency likely view a company operating in an industry with high risks, when determining its credit rating?
According to the information, how would a credit rating agency likely view a company operating in an industry with high risks, when determining its credit rating?
In the context of corporate finance, what is the critical implication of recognizing the existence of bankruptcy costs when determining a firm's optimal capital structure?
In the context of corporate finance, what is the critical implication of recognizing the existence of bankruptcy costs when determining a firm's optimal capital structure?
A distressed company is facing a loss of key customers and suppliers due to concerns about its long-term viability. What type of costs are these categorized as?
A distressed company is facing a loss of key customers and suppliers due to concerns about its long-term viability. What type of costs are these categorized as?
In the event of a corporate liquidation in France, which best describes the payment priority among different types of creditors?
In the event of a corporate liquidation in France, which best describes the payment priority among different types of creditors?
A firm has a ratio of corporate debt to pretax operating profits which is high relative to its industry peers. According to the content, what is the most likely implication of this?
A firm has a ratio of corporate debt to pretax operating profits which is high relative to its industry peers. According to the content, what is the most likely implication of this?
Flashcards
Tax Rate Differences
Tax Rate Differences
Taxes on dividends, capital gains, and interest income are often different.
Indifference of Tax-Exempt Investors
Indifference of Tax-Exempt Investors
Tax-exempt entities don't care about the form of investment income as long as it does not affect CFs
Tax-Exempt Investors and Leverage
Tax-Exempt Investors and Leverage
Tax-exempt investors tend to prefer investing in firms with high leverage, as total after-tax corporate CF are larger when the firm is levered.
Preference for Capital Gains
Preference for Capital Gains
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Taxed Investors and Leverage
Taxed Investors and Leverage
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French Standard Corporate Tax Rate
French Standard Corporate Tax Rate
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French Reduced Corporate Tax Rate
French Reduced Corporate Tax Rate
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French Personal Tax Rate on Gains/Interest
French Personal Tax Rate on Gains/Interest
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Tax-Free Pension Funds (France)
Tax-Free Pension Funds (France)
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Tax Deductible Dividends (France)
Tax Deductible Dividends (France)
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French Parent Company Regime
French Parent Company Regime
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Debt Tax Shield Limitation
Debt Tax Shield Limitation
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Risk of Debt
Risk of Debt
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Assessing Debt Risk
Assessing Debt Risk
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Key Credit Rating Agencies
Key Credit Rating Agencies
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Rating Scales
Rating Scales
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Factors Beyond Financials
Factors Beyond Financials
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Corporate Rating Criteria
Corporate Rating Criteria
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Interest Coverage Ratio
Interest Coverage Ratio
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Determining Optimal Capital Structure
Determining Optimal Capital Structure
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Bankruptcy Costs
Bankruptcy Costs
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Creditor Payment Priority
Creditor Payment Priority
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US Bankruptcy Code: Chapter 7
US Bankruptcy Code: Chapter 7
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US Bankruptcy Code: Chapter 11
US Bankruptcy Code: Chapter 11
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Difference between Direct and Indirect Costs
Difference between Direct and Indirect Costs
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Study Notes
Capital Structure
Miller and Personal Taxes (Section 5)
- Merton Miller's 1977 study examined the influence of personal investor taxation on capital structure
- Capital structure has little to no impact on the value of the firm
- Effective bankruptcy costs are low
- Between 1930 and 1950, the corporate tax rate in the US rose from 10% to 52% without impacting leverage
- Tax benefits of debt are lower than assumed in MM2 (1963)
- The debt tax shield does not entirely explain leverage
- Taxes on dividends, capital gains, and interest income differ
- Tax-exempt investors are indifferent to the form of cash flows (interest, dividends, or capital gains), as long as the payment does not affect cash flows
- Tax-exempt investors prefer to invest in firms with high leverage
- Investors subject to taxation prefer capital gains due to lower tax rates and deferral benefits, favoring firms with low leverage
- The tax shield that should result from debt disappears
Personal Tax Rates in France (2023)
- Capital gains tax has a withholding tax of 12.8% plus 17.2% in social charges, totaling 30%, or income tax if it is more advantageous plus 17.2%; detention allowances that existed before 2018 no longer exist
- Interest income tax has a withholding tax of 12.8% plus 17.2% in social charges, totaling 30%, or income tax if it is more advantageous plus 17.2%
- Dividend tax for individual investors has a withholding tax of 12.8% plus 17.2% in social charges, totaling 30%, or income tax if more advantageous.
- Option for income tax scale: The 40% allowance is applied to the amount of dividends only for the choice of income tax scale
- Example for a marginal rate of 30%: (0.6x0.3) + 0.172 = 35.2% choose withholding tax of 30%
- Pension funds are not subject to taxes for dividends nor capital gains
- Dividends of long-term investors are almost entirely tax deductible, given no withdrawal for 5 years
- If holdings are greater than 5%, dividends paid by a daughter company are tax-exempt except for 5%, similar to long-term capital gains
Corporate Taxes in France (2023)
- The standard rate is 25% on the entire taxable income for all companies.
- A reduced rate of 15% applies to companies meeting two criteria: revenue less than €10 million and capital fully paid up and held at least 75% by individual investors or a company that meets this same criteria
- The 15% rate applies up to €42,500 in profits for small companies; any profit beyond this threshold is taxed at i.e. 25%
- The turnover limit of €10 million is calculated as a turnover for a financial year or a period of 12 months
Bankruptcy Costs (Section 6)
- Estimating the risk of the debt and understanding bankruptcy risk in relation to optimal capital structure are important.
- Interest rate risk is linked to interest rate fluctuations and affects loans regardless of the lender.
- The risk is that debt is not repaid relating to firm bankruptcy or credit risk for the lender
- Shareholders' liability is limited, and there is the rate at which a firm borrows is no longer the risk-free rate.
- Default spreads depend on the rating
Estimating the risk of debt
- Rating agencies, like Moody's, Standard and Poor's, and Fitch, assess risk
- COFACE assesses commercial debt maturing in under 6 months, with amounts ≤ $100,000
- The Banque de France rating (Fiben) covers a large number of French companies, around 280,000
- The criteria rating agencies is the standard and Poor uses risk factors for corporate rating, including country risk,. sector risks and competition
Bankruptcy Risk
- Introduction of bankruptcy costs impacts MM2's reasoning
- Taking into account bankruptcy costs and income tax allow corporations to make capital structure adjustment that is optimal
- VL = VU + PV(tax shield) – PV of E(bankruptcy costs).
- Corporate tax only yields total tax savings less than <TD, the present value without bankruptcy.
- With personal taxes, total tax savings < GD, the present value without bankruptcy.
Expected Bankruptcy Costs
- This calculation is bankruptcy costs times the probability of bankruptcy, since more debt tends to increase bankruptcy costs
- Bankruptcy costs include legal costs and intermediaries
- Expected bankruptcy costs increase with the level of debt.
- Companies facing significant bankruptcy costs or a high likelihood of bankruptcy will opt for less debt.
- Do not confuse costs of bankruptcy with the losses that are the cause of bankruptcy
Bankruptcy Costs Breakdown
- Direct costs include lawyers, audit firms, and accountants
- Indirect costs include loss of: customers, suppliers, qualified employees, and assets, in addition to losses on accounts receivable
Priority of Creditors in France After Liquidation
- Super privilege: Salary claims from the last two months before the procedure was initiated have first priority
- Creditors after the opening of the procedure
- Then, creditors holding a general lien
- Secured creditors
- Unsecured creditors
- Subordinated creditors
US Bankruptcy Code
- Chapter 7 defines liquidation in the UK
- Chapter 11 defines administration in the UK
- Chapter 7 sees the bankruptcy court selecting a trustee who liquidates assets and distributes them to debtholders, with remaining proceeds going to shareholders
Chapter 11 Bankruptcy Administration
- A more complex process, where debt and equity holders receive new financial claims like equity for debt.
- The company creates a reorganization plan within 120 days for creditors to approve or reject.
- Creditors and equity holders must vote, and the plan is adopted by a judge if nondiscriminatory, fair, and equitable.
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Description
Notes on Merton Miller's 1977 study on personal investor taxation influence on capital structure. It covers tax benefits of debt, bankruptcy costs, the impact of tax-exempt investors, and the preference of taxable investors for capital gains due to lower tax rates.
