Summary
RSK4803 Topic 5 Learning Unit 15 summary notes
- Institution
- University Of South Africa (Unisa)
RSK4803 Topic 5 LU 15 notes
[Show more]
Content preview
Topic 4Learning unit 15
• Discuss the model flow of the Deutsche Bank Liability Structure Model.
• Discuss the benefits of debt.
Tax shields.
T the reduction in the corporation’s tax liability due to deductibility of interest expense
is the most important financial benefit of debt in the capital structure decision process. To
model the tax shield of debt, we compare the tax liability incurred with debt to the liability
incurred if the company had no debt. Loss carry forwards, the Alternative Minimum Tax, and
accelerated tax depreciation all can reduce the value of the interest tax shield. While debt is
tax advantaged at the corporate level, the relative advantage of debt over equity is typically
reduced once both corporate and investor taxes are considered. The differential tax rates on
interest income, dividend income, and capital gains that are specified in each country’s tax
code are key drivers of the net tax benefit of debt.
Temporary use of debt to finance capital expenditures
or dividends.
Too much debt on a permanent basis is dangerous, but the flexibility to fund expenditures
temporarily using more debt can be beneficial. That is, when companies cannot fully fund
value-adding capital projects and (in some cases) maintain the common stock dividend,
shareholder value can be lost. If we assume that the cost of issuing new equity is high, it
may be advantageous for the company to increase debt temporarily to fund the shortfall and
avoid the opportunity cost of not making the investment (or maintaining the dividend
• Discuss the cost of debt.
Cost of debt is the interest a company pays on its borrowings. It is expressed as a
percentage rate. In addition, cost of debt can be calculated as a before-tax rate or an after-
tax rate. Because interest is deductible for income taxes, the cost of debt is usually
expressed as an after-tax rate.
• What are the business effects of credit downgrades?
The Business Effects of Credit Downgrades
When a company’s credit deteriorates, particularly below investment grade, the company
finds it increasingly difficult to negotiate favourable payment terms with its suppliers. As
payments are accelerated, the payable account declines and must be replaced by interest-
bearing debt. Interest costs on incremental working capital are the indirect result of lower
credit ratings
, 15.2. Contingent Capital: Integrating Corporate Financing and Risk Management
Decisions
• Explain the concept of contingent capital
With contingent capital, by contrast, a company pays an investor a fixed price or premium
for the right (but not the obligation) to issue paid-in capital la ter. In other words, contingent
capital is essentially a type of option on paid-in capital. Like any ordinary option,
contingent capital can be characterized by a number of key features: (1) the
underlying asset (or just “the underlying”); (2) the exercise style of the option (European or
American or other); (3) the time period (or “tenor”) of the option; and (4) the strike price. In
addition to these standard attributes of normal options, contingent capital facilities also often
contain “barriers,” or “second triggers,” that are linked directly to their risk management role.
• Discuss the key features of contingency capital
The underlying asset
The Underlying Asset
Contingent capital gives a firm the option to issue paid-in debt, equity, or hybrid capital (such
as fixed-rate preferred stock), which can be thought of as the underlying asset of the option.
Many firms thus rely on such facilities as a form of pre-loss financing
Tenor
Regardless of the maturity of the financial capital claim that a firm may issue in a contingent
capital facility, the option to issue the contingent capital has a clearly limited duration
Exercise style
Like regular options, a contingent capital facility may entitle its buyer to use the facility and
obtain paid-in capital on only a few specific dates (which characterizes a Bermuda-style
option) or only when the contingent capital facility expires (i.e., European-style). But most
contingent capital facilities are American-style and allow their owners to exercise throughout
the life of the option.
Strike price
A contingent capital facility also includes a “strike price,” which is reflected in the pre-
specified terms on which the paid-in capital will be issued if the purchaser of the facility
exercises its right to draw upon that facility. As mentioned earlier, the strike price is often set
to reflect pre-loss issue terms. And since the price for the new issue is set prior to the
realization of a loss arising from a specified risk, the facility is likely to be at-the-money at the
time of its inception. Nevertheless, some contingent capital facilities are constructed such
that, if and when exercised, the terms of the underlying securities are reset to make them at-
the-money at the time of exercise.
These are referred to as post-loss financing facilities
The benefits of buying summaries with Stuvia:
Guaranteed quality through customer reviews
Stuvia customers have reviewed more than 700,000 summaries. This how you know that you are buying the best documents.
Quick and easy check-out
You can quickly pay through EFT, credit card or Stuvia-credit for the summaries. There is no membership needed.
Focus on what matters
Your fellow students write the study notes themselves, which is why the documents are always reliable and up-to-date. This ensures you quickly get to the core!
Frequently asked questions
What do I get when I buy this document?
You get a PDF, available immediately after your purchase. The purchased document is accessible anytime, anywhere and indefinitely through your profile.
Satisfaction guarantee: how does it work?
Our satisfaction guarantee ensures that you always find a study document that suits you well. You fill out a form, and our customer service team takes care of the rest.
Who am I buying this summary from?
Stuvia is a marketplace, so you are not buying this document from us, but from seller labuscwm. Stuvia facilitates payment to the seller.
Will I be stuck with a subscription?
No, you only buy this summary for R100,00. You're not tied to anything after your purchase.
Can Stuvia be trusted?
4.6 stars on Google & Trustpilot (+1000 reviews)
67474 documents were sold in the last 30 days
Founded in 2010, the go-to place to buy summaries for 14 years now