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 functions in company 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 concerns. It develops a number of new effects and exhibits how larger fee of capital and marginal tax expense estimates may be generated. The book's unified rate of capital thought is mentioned with accomplished numerical examples and graphical illustrations. This booklet may be of curiosity to company managers, lecturers, funding bankers, governmental firms, and personal businesses that generate price of capital estimates for public intake.

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Example text

They demand a coupon the risk of the t = 1 debt cash flow, Φ rate that equates their expected return with their opportunity cost ˜ D ) = kD ] so that VD = D. The par yield is the coupon rate r [E(R 12:22 ˜ NT S,p = MIN [X ˜p T, AT ] Φ Xp T AT Xp T AT AT Xo T VNTS = Cases ˜ N TS ) E π X (Φ 1+rz ˜ E π X MIN [XT,AT ] 1+rz = VNT S by pricing case, using Equation (11) πX AT +(1−πX )AT 1+rz 3, 4, 6–8, 10–12, 15, 17, 18 AT 1+rz πX Xo T +(1−πX )Xp T 1+rz 19, 20 Cases = βNTS = ΦNTS,o −ΦNTS,p VNTS · θX re,o −re,p = ΦNTS,o −ΦNTS,p πX ΦNTS,o +(1−πX )ΦNTS,p 1, 2, 5, 9, 13, 14, 16 3, 4, 6–8, 10–12, 15, 17, 18 · θX (1+rz ) re,o −re,p AT −AT πX AT +(1−πX )AT Xo T −Xp T πX Xo T +(1−πX )Xp T · A−Xp πX A+(1−πX )Xp = θX (1+rZ ) re,o −re,p · θX (1+rz ) re,o −re,p = Xo −Xp ˜ E π X (X) · θX (1+rz ) re,o −re,p =0 · θX ·(1+rz ) re,o −re,p = βX ch04 19, 20 AT −Xp T πX AT +(1−πX )Xp T θX (1+rz ) re,o −re,p 9in x 6in βNTS by pricing case, using Equation (12) · A Theory of the Firm’s Cost of Capital πX AT +(1−πX )Xp T 1+rz 1, 2, 5, 9, 13, 14, 16 spi-b456 A Theory of the Firm’s Cost of Capital ˜ NT S by pricing case (Table 3) and by state of nature (“o,” “p”) Φ 1, 2, 5, 9, 13, 14, 16 3, 4, 6–8, 10–12, 15, 17, 18 19, 20 December 12, 2006 ˜ NT S,o = MIN [X ˜o T, AT ] Φ Cases 28 Table 4.

08 11:15 Initial investment, A Corporate tax rate, T Expected return on a zero-beta asset, r December 12, 2006 (Continued) Numerical Illustration Table 8. ch07 49 2nd Reading December 12, 2006 11:15 spi-b456 A Theory of the Firm’s Cost of Capital 9in x 6in ch07 A Theory of the Firm’s Cost of Capital 50 2 x 2 example 35% r 30% 25% r(1−MTR) r(1−T) 20% kD 15% 10% 5% 0% 0 20,000 40,000 60,000 80,000 100,000 120,000 D 5 x 5 example 70% r 60% r(1−MTR) 50% r(1−T) 40% 30% 20% kD 10% 0% 0 20,000 40,000 60,000 80,000 100,000 120,000 D Figure 3.

It is not easy to generalize the implications of the pricing cases in Table 3. The relevant pricing case depends on the magnitudes of the borrowing rate, the investment’s pre-tax NPV, and the value of the tax shields. 1 shows that in cases 1–8 NPV A may be positive or negative, in cases 9–12 it is strictly positive, and in cases 13–20 it is strictly negative. Thus, our analysis accommodates both positive and negative NPV firms. This is interesting because it establishes an economic linkage between an investment’s economic viability and the cost of capital.

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