By Ramesh K. S. Rao
The price of capital proposal has myriad functions in company decision-making. the traditional method for deriving price of capital estimates is predicated at the seminal Modigliani-Miller analyses. This publication generalizes this framework to incorporate non-debt tax shields (e.g., depreciation), interactions among the borrowing cost 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 may 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, lecturers, funding bankers, governmental companies, and personal businesses that generate price of capital estimates for public intake.
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Additional info for A Theory of the Firm's Cost of Capital: How Debt Affects the Firm's Risk, Value, Tax Rate, and The...
Our interest in this research is not on these cases per se; they serve only to ensure that the resultant cost of capital theory is consistent in every one of these cases. It is useful to illustrate, with reference to a speciﬁc situation, how Table 3 is used in developing our cost of capital results. Consider, for example, the situation where A < D. 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.
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. The debt is riskless in case 12, since creditors are fully paid in both states of nature. The debt is risky in cases 9–11, since state “p” entails partial default on interest or principal or on both. The depreciation tax shield is riskless in cases 10–12, since the cash ﬂow from the depreciation deduction is a constant AT in ˜ NTS in Table 2).
Impact of an incremental debt dollar on levered ﬁrm risk and value. 3rd Reading December 12, 2006 11:15 spi-b456 A Theory of the Firm’s Cost of Capital 9in x 6in Discussion of Results ch05 3rd Reading 39 ~ Φ D+E ΦD+E, o ΦD+E, p Xp Xo A+rD A+r D ~ X Scenario 3. An incremental debt dollar produces no incremental tax shield. βD+E and VD+E are unaﬀected. This situation arises in cases 13–20: Xo A + rD. Figure 2. (Continued) incremental debt dollar generates tax shields in both the “o” and the “p” states, causing levered ﬁrm cash ﬂows to increase by an equal amount.