Question

According to the managerial entrenchment? theory, managers choose capital structure so as to preserve their control of the firm. On the one? hand, debt is costly for managers because they risk losing control in the event of default. On the other? hand, if they do not take advantage of the tax shield provided by? debt, they risk losing control through a hostile takeover. Suppose a firm expects to generate free cash flows of $94 million per? year, and the discount rate for these cash flows is .8%. The firm pays a tax rate of 40%. A raider is poised to take over the firm and finance it with $1,045 million in permanent debt. The raider will generate the same free cash? flows, and the takeover attempt will be successful if the raider can offer a premium of 29% over the current value of the firm. According to the managerial entrenchment? hypothesis, what level of permanent debt will the firm? choose?

Answer 1

Unlevered Value  
= Free cash flow per year / dicount rate
= 94 million / 0.08
= 1.175 billion
Levered Value with Raider
= unlevered value + tax rate x finance value
= 1.175billion + 40% x 1.045billion
= 1.175 + 0.418
= 1.593 billion $
To prevent successful raid, current management must have a levered value of at least
= Levered Value with Raider / ( 1 + premium)
= 1.593 billion / ( 1+0.29)
= 1.593 billion / ( 1+0.29)
= $ 1.23488372093 billion?
Minimum tax shield
= 1.23488372093 billion - 1.175 billion
= 59.88372093 million
According to the managerial entrenchment hypothesis, what level of permanent debt will the firm choose
= Minimum tax shield / Tax rate
= 59.88372093 million / 0.40?
= 149.709302325 million