The payment of interest (amortization) is fully tax deductible. But unpaid debt is a liability of the firm, and it may result in liquidation or bankruptcy. Thus one of the cost of issuing debt is the possibility of financial failure, which do not arise when equity is issued.
Because of the benefits and costs associated with debt, the capital-budgeting decision is different for levered firms than for unlevered firms.
There are 3 methods for capital budgeting by levered firms:
- the adjusted present value = discounted unlevered cash flows at the cost of capital for project in a unlevered firm + additional effects of debt (tax shield, flotation costs, bankruptcy cost, benefit of non-market rate financing)
- the flows to equity= discounted levered cash flows (after interest) at the cost of equity capital with leverage – (initial investment- amount borrowed)
- the weighted average cost of capital= unlevered cash flows discounted at the WACC - initial investment
The WACC and the FTE are more often used that the APVThe effect of leverage means that the return on equity is bigger when more debt is used. The leverage is the return of the project less the interest of the debt * the ratio debt/equity used.
If there is a 10 % for a project financed in 2/3 with debts at 8 % after tax, the return on equity is 10 % + the leverage (= (10-8)* (2/1))= 14 %
MM's propositions and market imperfections >>
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Corporate finance
The subject: corporate finance
PART ONE: CAPITAL EXPENDITURE
The present value
Investment
decisions
Practical
problems in capital budgeting
Firms evaluation
PART TWO. BASICS OF FINANCE
The financial
markets
Options
The market
efficiency
Risk
Mergers,
Acquisitions, and Corporate Control
International
Financial Management
PART THREE FINANCING DECISIONS
Corporate
financing
Dividend policy
and capital structure
PART FOUR FINANCIAL MANAGEMENT
Financial
planning
Short-term
financial management
Courses created and updated by Dr David Chelly, PhD in Management sciences from the University of Tours.
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