Purpose of Internal Control System

1. What are the potential advantages and disadvantages to a company's shareholders if the company increases the proportion of debt in its capital structure?

Soln: The advantage of using debt is that it may increase the returns to the company's shareholders. However, the disadvantage is that using debt increases the risk of an investment in the company's shares. An increased use of debt is justified where it results in an increase in shareholders' wealth--that is, the advantage of the increase in returns outweighs the disadvantage of an increase in risk. The MM analysis shows that any such increase in shareholders' wealth can arise only from taxes or imperfections such as agency costs.

2. Distinguish between business risk, financial risk and default risk.

Soln: Business risk is the risk inherent in a company's operations, and will depend largely on the industries in which the company operates.

Financial risk is the additional risk to which shareholders are exposed due to a company's use of debt finance.

Default risk is the risk that a borrower may fail to make the repayments that are due to lenders.

Both financial risk and default risk are associated with debt finance, but the two risks can be distinguished. In particular, any borrowing by a company will cause financial risk, even if the risk that the borrower may default is zero.

5. Outline Miller's argument that the tax advantages of debt are reduced or completely offset once personal taxes are included in the analysis. How appropriate is Miller's analysis, given the Australian tax system?

Soln: Miller suggests that where the effective (personal) tax rate on income derived from holding debt exceeds that on income from holding shares, then any advantage from the tax deductibility of interest payments at the company level will be reduced or totally offset. The discussion of the Australian tax environment in Chapter 12 suggests that most taxpayers do pay tax at a higher rate on income from debt than on income from shares. In addition, there are some investors who pay no tax on income from financial assets (charities, universities and other tax-exempt investors). It is this latter group that receives most of the tax benefits associated with the use of debt by companies. Miller's analysis was appropriate to Australia under the classical tax system, because the effective tax rate on income from debt was higher than that on income from shares. Under the imputation tax system, Miller's conclusion holds, but in this case, it results from the structure of the tax system rather than from a competitive equilibrium. (Therefore, it is not correct to say that his analysis applies under imputation.) In particular,

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