Solutions to Chapter 15

Debt Policy

1. a. True.

b. False. As leverage increases, the expected rate of return on equity rises by just enough to compensate for its higher risk. The stock price and stockholders’ wealth are unaffected.

c. False. The sensitivity of equity returns to business risk, and therefore the cost of equity, increase with leverage even without a change in the risk of financial distress.

d. True.

2. While the costs of both debt and equity increase, the weight applied to debt in the cost of capital formula also increases. Applying a higher weight to the lower-cost source of capital offsets the increase in the cost of debt and the cost of equity.

3. The interest tax shield is the reduction in corporate income taxes due to the fact that interest is treated as an expense that reduces taxable income. To the extent that the government collects less tax, there is a bigger pie of after-tax income available to the debt and equity holders.

Example: Assume operating income is $100,000, the interest rate on debt is 10%, and the tax rate is 35%. Compare income for an unlevered firm versus a firm that borrows $400,000:
| |Zero-debt firm |$400,000 of debt |
|Operating income |$100,000 | $100,000 |
|Interest on debt | 0 | 40,000 |
|Before-tax income | 100,000 | 60,000 |
|Tax at 35% | 35,000 | 21,000 |
|After-tax income | 65,000 | 39,000 |
|Sum of debt interest plus |