Katherine Epler, a self-employed corporate finance consultant, is having a discussion with friends that are also in the corporate finance field. After talking about their families, the discussion turns to factors that tend to impact capital structure. During the course of the conversation, Epler makes two statements. Statement 1: Favorable tax rates on dividend income relative to interest income will reduce the value of the tax shield provided by debt in the static trade-off theory of capital structure. Statement 2: Evidence indicates that reductions in the net agency costs of equity tend to lead to lower financial leverage ratios. With respect to Epler’s statements: A) both are correct. B) both are incorrect. C) only one is correct. _____________________________________________________________________ Please explain your reasoning
I will go with B. I think statement 1 is incorrect b/c if equities become more sought after due to more favorable tax treatment, I would think a company would have to offer greater interest income to the investor to compensate. This would increase the tax shield. I will say that reducing the net agency costs of DEBT would decrease leverage ratios, but not equity. so statement 2 is incorrect too. What is the answer? These were tough and I feel like I’m wrong.
I will go with C 1 - Incorrect, does not make sense 2 - Correct. Agency costs decreasing means less leverage
A 1. Static trade off is bankruptcy vs. tax savings, no dividends apply 2. Had a hard time grappling with this one, but I think lower costs of equity reduces debt reliance, lowering leverage ratios…
only one is correct. I dont think Div tax rate has anything to do with the tax shield on Debt. For the second statement, one of the “remedies” to the principal-agent problem is to load up on debt in order to give prevent managers for misusing or mismanaging the funds of the company. So I believe statement 2 is correct. If there isnt any agency issue then there shouldnt be the need to increase debt and thereby leverage.
div tax rate does affect debt vs. equity choice. but the wrong part of that answer is that it relates to Static Trade off. If you get lower tax rate on dividends - as against interest expense - company would prefer dividends. It is however not related to static trade off theory as stated. when agency cost decreases - more leverage would be used. [Managers have less incentive to manipulate, more controlled - more cash flows would flow towards debt service repayments]. so both statements are incorrect.
The correct answer was A. Epler’s first statement is correct. Miller (of Modigliani and Miller) concluded that if investors face different tax rates on dividend and interest income, the advantage for debt financing may be reduced somewhat. This conclusion is supported by international capital structure differences as countries with favorable dividend tax rates tend to use less debt in their capital structure. Epler’s second comment is also correct. When looking at international differences in capital structure, countries that have factors in place such as stronger legal systems and a greater presence of analysts and auditors tend to reduce agency costs and therefore also have lower financial leverage ratios. Note that higher leverage ratios tend to reduce agency costs, but reducing agency costs does not lead to higher leverage ratios. muffin09 was almost on the right track. this threw me for a loop as well and when i reviewed cfa text bk3 pg127 Miller from M&M relates it to investors facing different tax rates on their div & interest income in their personal taxes. Higher taxes on interest income vs div income = u demand a higher rate of return on debt = higher cost of debt. they add that income from debt pays interest periodically which u pay tax on vs div income where you only pay taxes after u sell the stock. as for agency costs - higher leverage means there is less freedom for managers to take on additional debt and spend company cash. since there is higher leverage the managers have to pay it off which reduces free cash flow - in essence managers interests are aligned with shareholder interests. not sure i FULLY understand the 1st part but it is what it is