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 proposal has myriad purposes in enterprise decision-making. the traditional method for deriving rate of capital estimates is predicated 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 cost and tax shields, and default issues. It develops numerous new effects and indicates how greater price of capital and marginal tax cost estimates will be generated. The book's unified fee of capital thought is mentioned with entire numerical examples and graphical illustrations. This booklet could be of curiosity to company managers, teachers, funding bankers, governmental corporations, and personal businesses that generate expense 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...

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16 Merton’s (1974) debt supply analysis ignores taxes. Miller’s (1977) debt supply arguments emphasize personal taxes and general equilibrium—tax shield risk is not the focus. 17 To express the cost of debt kD in terms of fundamental parameters, eliminate r using the par yield expressions from Table 5. December 12, 2006 30 12:22 Cases Debt is risky, but no taxes are paid in state “p” (case 11) =D πX D(1 + r) + (1 − πX)Xp =D 1 + rz πX D(1 + r) + (1 − πX)(Xp (1 − T ) + (A + rD)T ) =D 1 + rz πX D(1 + r) + (1 − πX)D(1 + r) =D 1 + rz Par yield „ rz + (1 − πX) “rD ”= D − Xp D « πX „ « D − (Xp (1 − T ) + AT ) rZ + (1 − πX) D “r11 ” = πX + (1 − πX)T rz 9in x 6in Debt is riskless (cases 2–4, 7, 8, 12, 14, 15, 18, 20) ˜ D (r)) E π X (Φ 1+rz ch04 A Theory of the Firm’s Cost of Capital Debt is risky, and firm pays taxes in states “o” and “p” (cases 1, 5, 6, 9, 10, 13, 16, 17, 19) VD = spi-b456 A Theory of the Firm’s Cost of Capital Table 5.

In state of nature “p,” Xp may fall in one of four A, the depreciation deduction is possible ranges. In case 9, Xp partially unused, and the debt tax shield is fully redundant (completely unused). In case 10, the depreciation deduction is fully taken while the debt tax shield is partially unused. In case 11, all tax shields are fully utilized and the firm pays taxes, but after-tax cash flow is insufficient to fully repay debt principal. In case 12, all tax shields are fully utilized, the firm pays taxes, and after-tax funds are sufficient to fully repay creditors.

Table 4 illustrates the risk and valuation calculations for the depreciation tax shield. First, cash flow from the depreciation deduc˜ N T S ) is computed for states of nature “o” and “p” for each tion (Φ of the 20 pricing cases in Table 3. Cases are combined where cash flows are identical. Three groups of cases exist for the depreciation tax shield. In the first group (cases 1, 2, 5, 9, 13, 14, and 16) the depreciation deduction is partially unused in state of nature “p,” and is risky. In the second group (cases 3, 4, 6–8, 10–12, 15, 17, and 18) the depreciation shield is a (riskless) constant AT in both states.

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