"Buy-backs are not necessarily a bad idea... But... both short-term investors and managers have incentives that could lead them to overdo buybacks and neglect investment projects. If firms are overdoing buy-backs and starving themselves of investments, artificially propped-up share prices will eventually tumble." (The Economist, 13 September 2014). Suppose a company faces no obvious risk of default, and decides to issue debt to repurchase equity. Explain why this could hamper its ability to take advantage of investment opportunities. Which of the following statements is FALSE? 1. A biotech firm might be developing drugs with tremendous potential, but it has yet to receive any revenue from these drugs. Such a firm will not have taxable earnings. In that case, a tax-optimal capital structure does not include debt. 2. No corporate tax benefit arises from incurring interest payments that regularly exceed EBIT. 3. In general, as a firm's interest expense approaches its expected taxable earnings, the marginal tax advantage of debt increases, limiting the amount of equity the firm should use. 4. The optimal level of leverage from a tax saving perspective is the level such that interest equals EBIT. Motivate your answer by rephrasing the wrong statement in the appropriate way. Which of the following statements is false? 1. If the financing of the project involves an equity issue, and if management believes that the equity will sell at a price that is less than its true value, this mispricing is a cost of the project for the existing shareholders. 2. When the debt level-and, therefore, the probability of financial distress-is high, the expected free cash flow will be reduced by the expected costs associated with financial distress and agency problems. 3. Sometimes management may believe that the securities they are issuing are priced at less than (or more than) their true value. If so, the NPV of the transaction, which is the difference between the actual money raised and the true value of the securities sold, should not be included in the value of the project. 4. An alternative method of incorporating financial distress and agency costs is to first value the project ignoring these costs, and then value the incremental cash flows associated with financial distress and agency problems separately. Motivate your answer explaining the source of the mistake contained in the false statement. "Buy-backs are not necessarily a bad idea... But... both short-term investors and managers have incentives that could lead them to overdo buybacks and neglect investment projects. If firms are overdoing buy-backs and starving themselves of investments, artificially propped-up share prices will eventually tumble." (The Economist, 13 September 2014). Suppose a company faces no obvious risk of default, and decides to issue debt to repurchase equity. Explain why this could hamper its ability to take advantage of investment opportunities. Which of the following statements is FALSE? 1. A biotech firm might be developing drugs with tremendous potential, but it has yet to receive any revenue from these drugs. Such a firm will not have taxable earnings. In that case, a tax-optimal capital structure does not include debt. 2. No corporate tax benefit arises from incurring interest payments that regularly exceed EBIT. 3. In general, as a firm's interest expense approaches its expected taxable earnings, the marginal tax advantage of debt increases, limiting the amount of equity the firm should use. 4. The optimal level of leverage from a tax saving perspective is the level such that interest equals EBIT. Motivate your answer by rephrasing the wrong statement in the appropriate way. Which of the following statements is false? 1. If the financing of the project involves an equity issue, and if management believes that the equity will sell at a price that is less than its true value, this mispricing is a cost of the project for the existing shareholders. 2. When the debt level-and, therefore, the probability of financial distress-is high, the expected free cash flow will be reduced by the expected costs associated with financial distress and agency problems. 3. Sometimes management may believe that the securities they are issuing are priced at less than (or more than) their true value. If so, the NPV of the transaction, which is the difference between the actual money raised and the true value of the securities sold, should not be included in the value of the project. 4. An alternative method of incorporating financial distress and agency costs is to first value the project ignoring these costs, and then value the incremental cash flows associated with financial distress and agency problems separately. Motivate your answer explaining the source of the mistake contained in the false statement
