FIN 401 Study Guide - Midterm Guide: Tax Shield, Risk Premium, Dividend Policy

• School: Ryerson University
• Department: Finance
• Course: FIN 401
• Professor: Melissa Toffanin

Document Summary

If the firm does poorly, stockholder losses are limited. Stockholders expropriate value from bondholders by selecting high-risk projects. Bondholders know that shareholders have an incentive to do this. Therefore, they put restrictive covenants in bond contracts and require a higher rate of return on their bonds. Both of these are costly to the firm, and increase the. Optimal capital structure=firm value is max=wacc is min. The tax shield only has value if the firm is making money. For firms with other substantial tax shields (i. e. cca tax shields), the interest tax shield is less important. The higher the corporate tax rate, the greater the incentive to borrow. The greater the risk of financial distress, the less the firm should borrow. The greater the costs of financial distress in the event of bankruptcy, the less you should borrow.