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 idea has myriad functions in company decision-making. the normal technique for deriving price of capital estimates relies at the seminal Modigliani-Miller analyses. This booklet 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 numerous new effects and exhibits how higher fee of capital and marginal tax price estimates might be generated. The book's unified expense of capital concept is mentioned with finished numerical examples and graphical illustrations. This booklet might be of curiosity to company managers, teachers, funding bankers, governmental organisations, and personal businesses that generate fee of capital estimates for public intake.

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Extra resources 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 is the case considered in the standard textbook result wherein debt lowers firm risk and hence the WACC. 23 Thus, for a firm with θX > 0, an extra dollar of borrowing may increase firm risk, if the incremental tax shield would not be fully utilized in all states. The intuition for these results is provided in Figure 2, which depicts three scenarios that are obtained in regard to the incremental tax shields from borrowing. The kinked lines in these figures show the cash flow to D + E for a given level of operating cash flows.

In scenario 3, borrowing does not affect the tax shields’ risk or firm value. Scenario 3 corresponds, however, to a firm with uneconomic investments (N P VA < 0, cases 13–20). Thus, a viable firm optimally borrows up to debt capacity, even when its cost of capital is increasing in the amount borrowed. This result is obtained because the increase in the firm’s expected cash flow arising from the marginal tax shields outweighs the effects of any increase in the WACC. ” Their argument, however, is a legal implication of equity’s limited liability (equity cannot have a negative value) and, since it says little about the debt level or firm value at which this upper bound is reached, it is not an economic explanation for the borrowing limit.

Thus, neither the CAPM nor the options theory is adequate for estimating the after-tax cost of capital for the (typical) firm with risky and potentially redundant debt and non-debt tax shields. 10 The economy has n traded assets. The linear projection of asset returns onto random variable ˜e is: ˜ ˜ =E R R n×1 n×1 + β · ˜e + ε˜ , n×1 1×1 n×1 (3) ˜ is the asset returns vector, ˜e is a pervasive, economy-wide where R risk factor, β is the vector of asset sensitivities to ˜e, ε˜ is the idiosyncratic returns vector, and E(˜e) = E(˜ ε) = E(˜eε˜ ) = 0 (this holds automatically when asset returns are projected linearly onto random variable ˜e).

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