Question

24. Assume Company XYZ’s currently has $1000 in total assets and the higher the firm’s debt level, the higher the risk of bankruptcy. If the CFO is looking to maximize firm value, Company XYX should:

    1. borrow an additional $400 in debt

    2. repay or retire $400 in debt

    3. borrow an additional $200 in debt

    4. repay or retire $200 in debt

    5. make no changes to the capital structure

Answer 1

Raising capital through debt is a trade off between two factors which impact firm value in opposite directions. The first factor is the benefit of the interest tax shield which accrues to the debt raising firm, thereby increasing firm value. Interest expense on debt is tax deductible which leads to the creation of a tax shield that benefits firm value. Consequently a higher level of debt leads to a higher value of the interest tax shield and more value accretion to the firm. The second factor is the increase in cost of debt that accompanies any etra debt being raised, as a higher level of debt implies higher risks of bankruptcy. The decision between retiring/reducing debt and raising more debt is an interplay of these two factors. Initially, at lower debt levels, raising more debt benefits the firm value owing to the interest tax shield. This occurs upto a threshold point beyond which any more debt would actually harm firm value owing to the greater cost of debt stemming from higher bankruptcy risks.

Therefore, if the CFO is looking at maximizing firm value he/she needs to determine this threshold point. If the existing debt level is below this threshold point, extra debt will increase firm value. The opposite will happen if existing debt is already beyond the threshold.