Last gripe with Schweser for the day: An analyst choosing between the free cash flow to the firm (FCFF) and free cash flow to equity (FCFE) valuation approaches recognizes that an increase in leverage: A) does not change FCFF. B) reduces FCFE by the amount of the debt. C) increases FCFE by the amount of after-tax interest. D) increases FCFF by the amount of the debt. The correct answer was A. FCFF is not changed by leverage. However, FCFE is increased by the amount of the debt and is decreased by the amount of after-tax interest. A few questions later… Assuming that Schneider, Inc., slightly increases its financial leverage, what should happen to its firm value? Firm value should: A) increase due to the additional value of interest tax shields. B) decline due to the increase in risk. C) increase due to the higher weighted average cost of capital. D) not change because financial leverage has no relationship with firm value. The correct answer was A. For small changes in leverage, the additional value added by the interest tax shields will more than offset the additional risk of bankruptcy / financial distress. Given the tax advantage of debt, the firm’s WACC should decline, not increase with small changes in leverage. Thoughts…?? the only thing I can think of is that leverage wont change the actually cash flows to the firm, but when valuing the firm, increased leverage will affect your WACC and thus change your valuation.
FCFF = NI +NCC - FCI - WCI + I(1-t) As you increase financial leverage the increase in the interest exp deducted from NI is offset by the the addition of I(1-t). So the increase in leverage doesn’t change FCFF. The increase in financial leverage changes the weights in the WACC formula. The heavier weight on the after tax cost of debt lowers the WACC and results in a higher firm value.
jbisback Wrote: ------------------------------------------------------- > Last gripe with Schweser for the day: > > An analyst choosing between the free cash flow to > the firm (FCFF) and free cash flow to equity > (FCFE) valuation approaches recognizes that an > increase in leverage: > > A) does not change FCFF. > > B) reduces FCFE by the amount of the debt. > > C) increases FCFE by the amount of after-tax > interest. > > D) increases FCFF by the amount of the debt. > > The correct answer was A. > > FCFF is not changed by leverage. However, FCFE is > increased by the amount of the debt and is > decreased by the amount of after-tax interest. Think of FCFF as the net funds disbursable to non-government claimants to the firm (esentially, CFs from the top half of the income statement adjusted for investments in NWC or fixed assets). So, financing activities don’t change it > A few questions later… > > Assuming that Schneider, Inc., slightly increases > its financial leverage, what should happen to its > firm value? Firm value should: > > A) increase due to the additional value of > interest tax shields. > > B) decline due to the increase in risk. > > C) increase due to the higher weighted average > cost of capital. > > D) not change because financial leverage has no > relationship with firm value. > Increases in leverage result in increased tax savings and also an increase in the likelihood of bankruptcy (there are costs associated with this). The increase in tax savings result at almost all levels of preexisting debt (as long as the firm is profitable). However, the increase in the probability of financial distress associated with a small increase in leverage is small for firms with low preexisting leverage. To see this, think of the change in risk associated with a firm going from a 0% debt ratio to a 30% debt ratio - there’s probably not an appreciable increase in the risk of financial distress. But going from 60% debt ratio to 90% would make a huge difference in the risk of distress. So, the first effect dominates at low levels of debt. The second diminates at high levels.
If the increase in leaverage cause you to get a lower wacc (i.e. you get closer to you optimal capital structure), then yes, firm value would increase. I guess that in the second question you had info to that effect (regarding Schneider, Inc.). The first question is much more general, and generally, we can only say that an increase (or even a change for that matter) in leverage will not change the FCFF but will change (one way or another depending to your relative position with the optimal capital structure) the FCFE.
I agree with Busprof’s reply. I think qn 2 is ambiguous. there is no correct answer to this. In my Financial Mgmt course, the professor repeatedly stressed that debt is good only upto a certain point after that the risk increases more than the rewards. I think it was MM theorem or something like that.
A increase in the level of debt, will increase your after tax interest expense, reducing your net cash flow. CF = 100 Int = 10 Tax rate = 40% Debt Rate = 8% Cost of Equity = 14% Debt ration = 60/40 Debt = 125 Equity = 85 so WACC = 0.6(0.08*0.6) + 0.14*0.4 = 8.5% Increase debt ratio to 70/40 WACC = 0.7(0.08*0.6) + 0.14*0.3 = 7.5 % So I did a few calcs on paper to work out debt and equity levels, after tax interest expense will increase by 1.00 So net effect is a decrease in CF of 1.00. So, comparing the two, assuming perpetuity & no growth, CFo = 100 / 0.085 = 1,176.47 & CF0 = 99.00 / 0.075 = 1320.00 So the NPV into perpetuity increase but NPV of cash flows (new debt structure) only start to better the old debt structure after the 2nd year (per my example) NPV of 2nd CF = 100/(1.085)^2 = 84.95 & CF = 99.00/(1.078)^2 = 85.19 So, assuming that the company is a going concern, a increase in the level of debt will increase the value of the firm. Kerry
bhaiyyu Wrote: ------------------------------------------------------- > I agree with Busprof’s reply. > > I think qn 2 is ambiguous. there is no correct > answer to this. In my Financial Mgmt course, the > professor repeatedly stressed that debt is good > only upto a certain point after that the risk > increases more than the rewards. I think it was MM > theorem or something like that. I think that the OP only posted part of the question. If that was a conceptual question, it would refer to “a company” But since it refers to “Schneider, Inc.”, I believe that the question had additional caracteristics of “Schneider, Inc.”, based on the additional data (missing from the post), one would infer the optimal capital structure of the firm, and conclued that a slight increase in leverage would be beneficial to the company (why do they say slight in the question? so that one understand that it’s not a move that would cause them to go on the other side of the optimal capital structure)