Lecture_3___Risk__Trans_cost___taxes_Fall08

Lecture_3___Risk__Trans_cost___taxes_Fall08 - Corporate...

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Corporate Financial Policy (NBA 558) Risk, Transaction Costs and Taxes Johnson Graduate School of  Management Fall 2008 Prof. Mark Leary
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2 Plan for Today Cost of risky debt Impact of transaction costs Impact of Taxes
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3 Interest rate and the cost of debt Example: a firm takes out a $100 million one-year loan with a stated interest rate of 10%. Projected cash flows in three possible states of the economy are as follows: What is the expected cash flow to debtholders? expected yield? E[ CF to debtholder ] = 0.1*50 + 0.9*110 = 104 Expected yield = 104/100 – 1 = 4% Bad Ok Good Prob 0.1 0.5 0.4 Total CF 50 120 200 CF to debtholders 50 110 110
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4 Interest rate vs. the cost of debt Is the “cost of debt” the promised yield or the expected yield? Expected yield In a debt issuance: Firm gets: Cash up front Default option Investors get: Promised yield conditional on no-default If debt is risk-free (no chance of default) β D = 0 R D = r f Interest rate = r f If debt is risky
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