Costs and Benefits of Debt (30%)
These questions are designed to develop your understanding of how leverage affects firm value. Your responses will be graded based on the quality and depth of the discussion. A good response in this section will demonstrate a clear understanding of the concepts discussed in class. A great response will be one that goes above and beyond the materials discussed in class and supports the discussion with new perhaps real-world examples. Company’s business characteristics, financial figures, ratios and news articles are good examples of what you may want to consider. Cite your sources clearly.
a. Briefly explain what the Trade-Off Theory is. What is its implication for capital structure? How do you explain why different firms may choose different capital structure? Illustrate your point conceptually using both the APV and WACC method.
b. While debt can be beneficial for firms that can utilize the interest tax shield, it can also come at a cost. Explain what risk-shifting is and give an example. How does it differ from debt overhang? Why and how might these problems be costly for investors of the firm? What kinds of companies are more likely to be prone to these problems? Be as specific as you can when describing those companies. Suggest ways to alleviate these problems.
c. You are having a coffee chat in downtown Evanston with a friend who has just started working as a stock analyst and are talking about leverage and firm value. While working, your friend noticed that Apple (AAPL), Peet’s Coffee (PEET), and Urban Outfitter (URBN) are all unlevered even though they have enough profits to bene t from the interest tax shield. They are also very cash-rich; Apple, for example, has over $9.8 billion in cash on its balance sheet as of September 2011. She concludes that all these firms are clearly not maximizing shareholder value, because they are leaving money on the table. Do you agree with her statement? Explain your answer completely. Hint: There is no definite answer for this question, so think of it as an open debate. Support your argument with facts and evidence. A simple repetition of the answers to the first two questions will not earn you any credit.