Corporate Finance

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

By Ramesh K. S. Rao

The price of capital thought has myriad purposes in enterprise decision-making. the traditional technique for deriving expense 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 expense and tax shields, and default concerns. It develops a number of new effects and exhibits how larger expense of capital and marginal tax expense estimates might be generated. The book's unified rate of capital conception is mentioned with accomplished numerical examples and graphical illustrations. This e-book should be of curiosity to company managers, teachers, funding bankers, governmental organisations, and personal businesses that generate rate 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

If historical data on Φ pop , ppo , ppp , Φi,o Φi,p , re,o , and re,p can be estimated using maximum likelihood methods. An alternative estimation strategy is to iterate on poo , pop , ppo , ppp , Φi,o , Φi,p , re,o , and re,p to produce desired ˜ i , VAR r˜e , and COV Φ ˜ i , r˜e . The ˜ i , E r˜e , VAR Φ values of E Φ 13 cash flow beta of asset i is : ˜ i,o − Φi,p · Bi = Φ θi , re,o − re,p where θi = poo ppp − pop ppo . (10) Pe,o Pe,p Equation (10) is crucial for our results since it simplifies the valuation of kinked payoffs.

22 The Marginal Effects of Borrowing on Firm Risk and the WACC The prevailing view is that with corporate taxes (and no bankruptcy costs), increasing debt lowers firm risk (the risk of D + E, βD+E ). This belief rests on the assumption that the debt tax shield is riskless. 1 into Equation (5). 3rd Reading December 12, 2006 11:15 spi-b456 A Theory of the Firm’s Cost of Capital Discussion of Results 9in x 6in ch05 3rd Reading 37 With risky debt and potentially redundant tax shields, we find that βD+E and the WACC may fall, remain constant, or even rise with leverage increases, depending on the extent to which the firm can utilize the incremental deductions, which in turn affects the risk of ˜ D+E .

When D > A, the debt claim is a long position in ˜ short T call options with strike price rD + A (total deductions) X, and short 1 − T call options with strike price X*. The equity claim ˜ with strike is the familiar long position in 1 − T call options on X price X*, but only when D > A. When D A, the equity claim is a ˜ with strike price D(1 + r) plus a short position long call option on X ˜ with strike price rD + A. The payoff to the in T call options on X ˜ plus short T call firm (D + E) is equivalent to a long position in X ˜ with strike price rD + A.

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