A Theory of the Firm's Cost of Capital: How Debt Affects the by Ramesh K. S. Rao

By Ramesh K. S. Rao

The price of capital thought has myriad functions in company decision-making. the traditional technique for deriving price of capital estimates is predicated at the seminal Modigliani-Miller analyses. This ebook generalizes this framework to incorporate non-debt tax shields (e.g., depreciation), interactions among the borrowing cost and tax shields, and default issues. It develops a number of new effects and exhibits how higher fee of capital and marginal tax expense estimates might be generated. The book's unified rate of capital conception is mentioned with entire numerical examples and graphical illustrations. This booklet might be of curiosity to company managers, lecturers, funding bankers, governmental enterprises, and personal businesses that generate price of capital estimates for public intake.

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Extra info for A Theory of the Firm's Cost of Capital: How Debt Affects the Firm's Risk, Value, Tax Rate, and The...

Example text

This question is particularly interesting because as just seen, the firm’s risk and its WACC can, in fact, increase with borrowing. 25 To see why, revisit Figure 2 and consider a firm with θX > 0. As noted in the figure, the risk of the tax shields and of the firm increases with the marginal debt dollar in scenario 1, but firm value also increases because the firm’s cash flows increase proportionately more than enough to compensate for the increase in risk. In scenario 2, debt lowers firm risk and hence increases firm value.

Four cases are possible: 3rd Reading A < X ∗: Xp A A < Xp < X ∗ X ∗ Xp A + rD A + rD < Xp Xo 16: rD , NTS, DTS, NPV A− 17: rD , DTS, NPV A− 18: rz , DTS, NPV A− X∗ 9: 10: 11: 12: A + rD 13: rD , NTS, DTS, NPV A− 14: rz , NTS, DTS, N P VA− 15: rz , DTS, NPV A− A + rD < Xo 1: 2: 3: 4: rD , NTS, DTS, NPV A+/− rz , NTS, DTS, N P VA+/− rz , DTS, NPV A+/− rz , NPV A+/− A + rD < Xo 5: rD , NTS, DTS, NPV A+/− 6: rD , DTS, NPV A+/− 7: rz , DTS, NPV A+/− 8 : rz , NPV A+/− Xo rD , NTS, DTS, NPVA+ rD , DTS, NPVA+ r11 , NPVA+ rz , NPVA+ ch04 25 rz : Debt is riskless and par yield = rz ; rD : Debt is risky and par yield = rD ; r11 : Debt is risky and par yield = r11 ; NTS: Depreciation (non-debt) tax shield is risky; DTS: Debt tax shield is risky; DTSW: Debt tax shield is worthless; NPV A+ : NPV A is positive; NPV A− : NPV A is negative or zero; NPV A+/− : Sign of NPV A may be positive or negative.

Our findings are summarized in Table 6, which compares the risk of the debt tax shields with that of the unlevered firm and the risks of the debt tax shields with the risk of the debt. Contrary to the routine assumption that the debt tax shield is as risky as the debt, we find that risky debt tax shields may be greater than, less than, or equal to the risk of both the debt and the unlevered firm. As seen in Table 6, the relative magnitudes of the debt tax shield risk versus the unlevered firm risk, and the risk of the debt relative to that of the debt tax shield risk are case specific.

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