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12 Nov 2019

What are direct costs and indirect cost of financial distress? What are the impacts of each cost on firm’s value?

Suppose you are a rational investor and looking at the following tax rates:

Year

Capital Gains Rate

Ordinary Income Rate

Dividend Rate

1997-2000

20%

40%

40%

2001-2002

20%

39%

39%

2003-

15%

35%

15%

The current tax rates are set to expire in 2008 unless Congress extends them. The tax rates shown are for financial assets held for one year. For assets held less than one year, capital gains are taxed at the ordinary income tax rate (currently 35% for the highest bracket); the same is true for dividends if the assets are held for less than 61 days. What is the effective dividend tax rate for a buy and hold individual investor in 2006 ?

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Keith LeannonLv2
21 Feb 2019
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1a- What are the direct costs and indirect costs of financial distress, from default that leads to bankruptcy? Explain in a well-stated description and discussion, not over a page in length.

1b- What are the impacts of the following on BECA Corporation's value, given the following information? SHOW ALL CALCULATIONS, and make a summary about the impact on equity owners between leveraged and unleveraged capital structures, and the impact on firm value from Financial Distress Costs.

BECA Corporation faces an uncertain future in a challenging business environment. Due to increased competition from foreign imports, its revenues have fallen dramatically in the past year. BECA's managers hope that a new product in the company's pipeline of new products will restore its fortunes. While the new product represents a significant advance over BECA's competition, whether that product will be a hit with consumers remains uncertain. If it is a hit, revenues and profits will grow, and BECA will be worth $200 million at the end of the year. If it fails, BECA will be worth only $130 million at the end of the year.

BECA Corporation may employ one of two alternative capital structures at the beginning of the year to provide the funding for this new project: (1) it can use all equity financing or (2) it can use debt that matures at the end of the year with a total of $150 million due.

Look first at the consequences of these capital structures when the new product succeeds, and when the new product fails, in a setting of perfect capital markets. Calculate what the debt and equity values will be for success and for failure, in both the unlevered and levered capital structures, at the end of the year. Show the totals to all investors (debt + equity) as well.

Now, since it has been assumed that BECA Corporation is operating in a perfect capital market, according to the M&M Proposition I, the investors (debt and equity total) will NOT be worse off because BECA may have some leverage at the beginning of the year. In other words, the value of BECA will be the same whether it has incurred the $150M of debt or not.

So, you are to show if that is indeed the case for BECA Corporation, under the following scenario.

Suppose the risk-free rate is 5%, and BECA's new product is equally likely to succeed or to fail. For simplicity, suppose that BECA's cash flows are unrelated to the state of the economy (i.e., the risk is diversifiable), so that the project has a Beta coefficient of 0 and the cost of capital is the risk-free rate. Compute the value of BECA's securities (that means both debt and equity, as applicable) at the beginning of the year with and without the $150M debt, and show whether or not the M&M Proposition I holds. That is, show if the value of the securities with or without leverage (the debt of $150M) have the same total value or not.

Now, to "get at" the value, VL or VU of the BECA Corporation, you have to discount the value of the cash flows to investors, per equation 9.23 in Chapter 9. But, what you need to know about the M&M Propositions is they assumed that the entire earnings (EBIT) in each year are paid out to the shareholders in the form of dividends or to the debtholders in the form of interest. So, regardless, the owners of the firm receive all the cash flows. So, for equation 9.23, you only have one year of FCFs, and the discount rate is 5%. What is the FCF? Since it is all of the cash flows with no taxes existing, and all of it is paid out to the equity and debt holders in a perfect capital market, what you find out is that the numerator is nothing more than the equity or debt values you calculated above. This is illustrated in Example 16.1 on page 554 of the texbook (I just provided an explanation of why the equity and debt values are used in the numerator instead of cash flows...in this case, they are the same).

2.Suppose you are a rational investor and looking at the following tax rates:

Year

Capital Gains Rate

Ordinary Income Rate

Dividend Rate

1997-2000

20%

40%

40%

2001-2002

20%

39%

39%

2003-2012

15%

35%

15%

(The 2012 tax rates were revised in 2013 by the U.S. Congress, and signed into law by the President, but that is for information only). The tax rates shown are for financial assets held for one year or more. For assets held less than one year, capital gains are taxed at the ordinary income tax rate (currently 35% for the highest bracket); the same is true for dividends if the assets are held for less than 61 days.

Your assignment: What is the effective dividend tax rate for a buy and hold individual investor in 2006 ?

Show all of your calculations.

1.Which of the following statements about conversion of income is correct?

a.

converting ordinary income into capital gain is a beneficial tax planning strategy
b.

converting capital gain income into ordinary income is a beneficial tax planning strategy
c.

converting qualifying dividends into interest income is a beneficial tax planning strategy
d.

holding assets that will generate a capital gain inside a retirement plan is a beneficial tax planning strategy

2. Which of the following statements is NOT a true statement regarding long-term capital assets?

a.

capital assets that are held for more than one year are treated as long-term
b.

no distinction is made between capital losses and ordinary losses
c.

with few exceptions, the maximum capital gains tax rate is 15%

the benefit of holding a capital asset long enough to garner long-term capital gain treatment must be weighed against the financial risk associated with a possible decline in value during the holding period

3. Which of the following statements about the taxation of dividends is correct?

a.

all dividends are taxed at the same rate as applicable to capital gains
b.

dividends paid by credit unions and mutual insurance companies qualify for the lower tax rate
c.

qualifying dividends are taxed at a maximum 15% rate

d. there is no tax benefit to changing some of an individual's funds from a lower-yielding fixed income investment into a dividend-paying stock

4. Which of the following is an advantage of making an IRC Section 83(b) election with respect to restricted stock?

a.

an 83(b) election can be made any time within the tax year of the transfer of shares from the company to the employee
b.

if the stock is forfeited, the compensation recognized and the taxes paid are deductible as losses
c.

any future appreciation would be taxed as capital gain instead of taxable compensation

d. the employee does not receive any cash at the time of the stock award to pay the tax on the compensation recognized under the election

5.The maximum alternative minimum tax rate for individuals is:

a.

less than the maximum regular federal income tax rate for individuals
b.

equal to the maximum regular federal income tax rate for individuals
c.

greater than the maximum regular federal income tax rate for individuals

d. going to decrease each year by 1% until it reaches 20% in 2010

6. How is alternative minimum taxable income (AMTI) for individuals computed?

a.

AMTI = taxable income + adjustments + preferences - exemptions
b.

AMTI = taxable income - adjustments + preferences - exemptions
c.

AMTI = taxable income +/- adjustments + preferences - exemption
.

d. AMTI = taxable income +/- adjustments - preferences - exemptions

7. Which of the following statements regarding the calculation of alternative minimum taxable income (AMTI) for corporations versus the calculation of AMTI for individuals is accurate?

a.

AMTI is calculated the same for both corporations and individuals
b.

an additional step is required for corporations based on their adjusted current earnings
c.

the exemption amount for corporations is not subject to phaseout to phaseout while the exemption amounts for individuals are
d.

thethere is no adjustments to taxable income for corporations, only preferences

1. You are an employee of University Investment Consultants, Ltd. and have been given
the following assignment. You are to present an investment analysis of a new small
residential income producing property for sale to a potential investor. The asking
price for the property is $1,250,000; rents are estimated at $200,000 during the first
year and are expected to grow at 3 percent per year thereafter. Vacancies and
collection losses are expected to be 10 percent of rents. Operating expenses will be
35 percent of effective gross income. A 70 percent loan can be obtained at 11 percent interest for 30 years. The property is expected to appreciate in value at 3 percent per year and is expected to be owned for five years and then sold.


. The asking
price for the property is $1,250,000; rents are estimated at $200,000 during the first
year and are expected to grow at 3 percent per year thereafter. Vacancies and
collection losses are expected to be 10 percent of rents. Operating expenses will be
35 percent of effective gross income

2. (Extension of problem 2) You are still an employee of University Consultants, Ltd. The investor tells you that she would also like to know how tax considerations affect your investment analysis. You determined that the building represents 90 percent of value and would be depreciated over 39 years (use 1/39 per year). The potential investor indicates that she is in the 36 percent tax bracket and has enough passive income from other activities so that any passive loans from this activity would not be subject to any passive activity loss limitations. Capital gains from price appreciation will be taxed at 20 percent and depreciation recapture will be taxed at 25 percent.

a. What is the investor’s expected after tax internal rate of return on equity invested (ATIRR)? How does this compare with the before tax IRR (BTIRR) calculated earlier?

b. What is the effective tax rate and before-tax equivalent yield?

c. How would you evaluate the tax benefits of this investment?

d. Recalculate the ATIRR in part (a) under the assumption that the investor cannot deduct any of the passive losses (they all become suspended) until the property is sold after five

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