By Ramesh K. S. Rao

The price of capital thought has myriad functions in enterprise decision-making. the traditional method for deriving fee of capital estimates relies at the seminal Modigliani-Miller analyses. This e-book 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 numerous new effects and exhibits how greater rate of capital and marginal tax price estimates will be generated. The book's unified rate of capital concept is mentioned with complete numerical examples and graphical illustrations. This e-book might be of curiosity to company managers, lecturers, funding bankers, governmental companies, and personal businesses that generate expense of capital estimates for public intake.

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

The price of capital idea has myriad functions in enterprise decision-making. the traditional method for deriving fee of capital estimates relies at the seminal Modigliani-Miller analyses. This publication generalizes this framework to incorporate non-debt tax shields (e. g. , depreciation), interactions among the borrowing fee and tax shields, and default issues.

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Additional 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

It cannot borrow any more, irrespective of how high a coupon rate that it is prepared to offer. Our result is consistent (as it should be) with limited liability, but our credit supply side route to debt capacity links the borrowing limit to characteristics of the output distribution and exogenous economic variables. 4). In this case, just as in MM, the firm borrows more than the value of the physical assets generating the cash flows. However, if N P VA ≤ 0 the firm can borrow no more than the value of its cash flows.

33 3rd Reading December 12, 2006 34 11:15 spi-b456 A Theory of the Firm’s Cost of Capital 9in x 6in ch05 A Theory of the Firm’s Cost of Capital The Cost of Risky Debt Consider the textbook question: What is the correct way to calculate the firm’s after-tax cost of risky debt when the tax shields are risky? 1) and hence creditors’ expected return, kD . Intuitively, tax adjustments are already included in kD , and no further tax adjustments are needed in determining the cost of debt. The economic cost of debt capital is the creditors’ opportunity cost, and it depends on the expected return on alternative investments with the same risk.

When A < X, is fully utilized and the cash flow from it is AT. The depreciation tax shield is equivalent to a long position in a riskless discount bond with principal TA plus a short position in 1 − T put options with ˜ strike price A. The debt tax shield (DTS ) is a bull spread on X, or long T call options with strike price A and short T call options with strike price rD + A. Because depreciation is deducted first, the ˜ < A; for each additional dollar of debt tax shield goes unused if X ˜ in the range A < X ˜ < rD + A, the debt tax shield provides a tax X ˜ the debt tax shield is fully savings of T dollars.

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