n class we held a discussion about a firm that was in financial distress, paid h
ID: 2651386 • Letter: N
Question
n class we held a discussion about a firm that was in financial distress, paid high property taxes, had a long term union contract with its workers, and was the defendant in a high profile lawsuit. In this example the firm was considering a project that had a small chance of a significant payout, but a large chance of returning zero. What was the justification of accepting the project and funding the project with new debt capital?
Debt is a riskier form of capital compared with equity, so that the financing risk better matches the risk of the project.
Debt leads to better diversification for investors who wish to form medium sized portfolios.
Debt is easier to raise compared with equity, especially in this particular scenario.
Debt is tax deductible and firms with leverage pay less in tax compared with unlevered firms.
Debt pays a fixed rate of interest, such that the project’s success would not have to be split with any new shareholders.
a.Debt is a riskier form of capital compared with equity, so that the financing risk better matches the risk of the project.
b.Debt leads to better diversification for investors who wish to form medium sized portfolios.
c.Debt is easier to raise compared with equity, especially in this particular scenario.
d.Debt is tax deductible and firms with leverage pay less in tax compared with unlevered firms.
e.Debt pays a fixed rate of interest, such that the project’s success would not have to be split with any new shareholders.
Explanation / Answer
The justification of accepting the project and funding the project with new debt capital is
e ) Debt pays a fixed rate of interest, such that the project’s success would not have to be split with any new shareholders.
The reasoning behind this is that the investment proposal is able to honour its cost of capital even if its NPV =0.Considering that the company is grappling with various issues ranging from law suits to taxes, this investment proposal will serve as a breather and will help the company concentrate on current project and may open the doors for various future investment proposal as well if it is able to execute this project successfully.
Apart from that, without any increase in equity, higer returns on equity through financial leverage would be appealing & acceptable to the existing shareholders and hence, there is no chance of equity dilution.
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