More interest tax savings need not mean a better policy

In a separate constructed comparison, an unlevered operating value of 200 is supplied on grounds that exclude the financing effects below. The alternatives are no debt, principal 40 for two years with annual interest 6%, or principal 80 for two years with annual interest 10%. The stated terms are obtainable. Both debts repay principal at the end of year 2; their service capacity is tested separately. The only tax effect is a fully usable 25% deduction for interest paid at each year end. A qualified 5% rate applies to these stipulated tax-saving cash flows; it is not inferred from either loan’s coupon.

The 40 loan pays interest 2.4 each year and saves tax 0.6 each year, so the saving’s present value is 0.6/1.05 + 0.6/1.05² = 1.12. The 80 loan pays interest 8 and saves tax 2 each year, worth 3.72 on the same stated basis. Nonoverlapping estimates put financing-induced operating and distress losses at present values 0.2 and 5 respectively; issue costs paid now are 0.2 and 0.5. These loss estimates are supplied case inputs, not universal percentages of debt.

The smaller debt has the highest value among these alternatives on the supplied grounds. If it fails the separate dated service or consent conditions, that does not make it available merely because its value is highest. If the larger policy’s additional loss falls below about 2.50, with all other grounds retained, its value exceeds the smaller policy’s value. That threshold identifies the consequential disputed estimate; extra decimal precision in the debt ratio would not settle it.

This comparison is of total value before allocation to claims. Deriving old owners’ wealth after an issue, repayment or payout requires the actual proceeds and ownership treatment. Subtracting all new principal as an additional resource loss here would misrepresent the borrowing; ignoring its claim when subsequently deriving equity value would be the opposite error.