EFN507 Chap.10 Debt, Taxes and the Costs of Financial Distress
Debt, Taxes and the Costs of Financial Distress
Why firms do not borrow without limit
Week 8 qualifies the tax case for debt. Myers's reading treats the corporate tax shield as an upper bound: firms are not always profitable, debt is not permanent, and personal taxes can favour equity income.
Miller argued personal taxes could cancel the corporate advantage completely, but measured tax rates suggest a real net advantage remains, so something else must hold leverage down.
Distress, information and agency
The tradeoff theory balances tax shields against the costs of financial distress, both the legal costs of bankruptcy and the damage done by shareholders' incentives near default: risk shifting, paying out cash, underinvestment and playing for time.
The pecking order theory explains why profitable firms borrow less and why share issues depress prices, and the free cash flow theory explains why high debt can discipline cash-rich managers.
What this chapter covers
- 01
Corporate and personal taxes on debt and equity income
- 02
Miller's equilibrium and the evidence against a full offset
- 03
Direct and indirect costs of financial distress
- 04
Shareholder games near default and debt overhang
- 05
The tradeoff theory and the profitability puzzle
- 06
The pecking order and free cash flow theories
Worked example · free
Debt overhang and a rejected project
- +1The project's NPV is 40 ÷ 1.1 − 25 = +$11.36m, so the firm as a whole gains.
- +2With the project the firm has $60m next year: lenders take $50m and shareholders $10m.
- +2Shareholders' NPV = −25 + 10 ÷ 1.1 = −$15.91m, so they refuse.
- +1Debt would gain 50 ÷ 1.1 − 20 ÷ 1.1 = $27.27m, equal to the project's $11.36m plus the shareholders' $15.91m loss.
Key terms
- Costs of financial distress
- The legal and administrative costs of default plus the value lost from poor decisions when default is likely.
- Debt overhang
- Underinvestment that occurs because much of the value from new equity-funded investment would go to existing lenders.
- Risk shifting
- Shareholders favouring riskier strategies near default because lenders bear most of the downside.
- Tradeoff theory
- The theory that firms borrow up to the point where marginal tax benefits equal marginal distress costs.
Debt, Taxes and the Costs of Financial Distress FAQ
Why is the corporate tax shield only an upper bound?
Firms are not always profitable, so the effective tax rate on interest saved is below the statutory rate. Debt is not permanent, so future tax shields are risky, and investors may pay more personal tax on interest than on equity income.
What are indirect costs of financial distress?
Delays in liquidation, poor investment and operating decisions while distress is resolved, and the costs created by the threat of default itself, such as lost customers or suppliers. They are often larger than the legal costs of bankruptcy.
What does playing for time mean?
Managers acting for shareholders delay the day of reckoning, for example by skipping equipment replacement or concealing problems, so lenders cannot force bankruptcy. That effectively extends the life of the debt and moves risk onto lenders.
Why do profitable firms often borrow less?
The pecking order theory says firms use internal cash first and borrow only when it runs out. Profitable firms generate more internal cash, so they need less debt. The tradeoff theory predicts the opposite, which is its main empirical difficulty.
Why does a share issue announcement lower the price?
Investors suspect managers issue shares when they think they are overvalued, so the announcement is read as bad news about existing assets. Myers cites an average fall of about 3% of market value; debt announcements have much smaller effects.
When can high debt add value?
In mature firms with more cash than good projects. Jensen's free cash flow theory says interest and repayments force managers to pay out cash they might waste, so debt can discipline management despite raising the risk of distress.
Exam move
For each shareholder game, write a one-line numerical example showing who gains and who loses. Then set out the tradeoff theory, the pecking order and Jensen's free cash flow view side by side in a three-row table.
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