134aF09Leverage

134aF09Leverage - Financial Leverage & Systematic Risk...

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Financial Leverage & Systematic Risk Reading: RWJ chp 12,17 Review 12.8, 12.16, 17.10, 17.15. Two key questions of corporate financial decisions: Valuation: How to distinguish between good investment projects and bad ones? Expand existing operations? Diversify into new products/services? Financing: How to finance the investment projects the firm has chosen to invest in?
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2 What is the best source of funds? Internal funds (Cash/RE)? Debt (borrowing)? Equity ( issuing stock)? And then, there are different kinds of . .. Internal funds (cash reserves vs. cutting dividends) Debt (Banks vs. Bonds) Equity (VC vs. IPO)
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4 Leverage refers to the use of debt as a financing option. The combination of debt and taxes impact on firm valuation and on shareholder value. Valuation and Capital Budgeting for the Levered Firm Financial Leverage: A firm’s mix of debt and equity. If a firm is unlevered – has no debt, all cash flows are paid to equity holders. The market value, risk and cost of capital for the firm’s assets and its equity coincide. Valuing levered firms requires an adjustment to the cost of capital or to projected cash flows.
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5 I. The weighted average cost of capital (WACC). This approach explicitly recognizes that levered firms are simultaneously financed with both debt and equity. Thus, the cost of capital is a weighted average of the cost of debt and the cost of equity. r* = r d D V + r e E V where r* = WACC. r d = the firm's current borrowing rate r e = the expected rate of return on the firm's stock D,E = market value of currently outstanding Debt and Equity respectively V = D + E = total market value of the firm
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6 All variables in the above formulation refer to the whole firm. This is the correct discount rate to use – but only for projects that are just like the firm undertaking
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134aF09Leverage - Financial Leverage & Systematic Risk...

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