RSM333 lecture3a - Sources of Financing Outline I. Debt Tax...

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Sources of Financing 3a Outline I. Debt s Tax shield s Short Term (treasury bill, CP) s Long Term (bonds) II. Equity s READ: 18.2-18.3-18.4 (bank, LT financing) 19.1-19.2-19.3 (shares, preferred shares)
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1 Sabrina Buti, Rotman School of Management, RSM 333 Can financing decisions create value? s First two lectures show how to evaluate investment projects according to the NPV criterion (or IRR, …) s The next chapters are about financing decisions: – How much debt and equity to sell – When (or if) to pay dividends – When to sell debt and equity
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2 Sabrina Buti, Rotman School of Management, RSM 333 Debt s Debt gives rise to fixed contractual commitments. s Rights of the debtholder – Right to a fixed interest payment – Right to reimbursement of the principal at maturity – Right to declare bankruptcy if the company does not pay interests / principal – Priority over other claimants if the debt is secured – Priority over other debtholders if the debt is senior
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3 Sabrina Buti, Rotman School of Management, RSM 333 Debt: Tax Shield Net cost of debt for the firm is the after tax cost of debt : (1 ) d K K T = - Interest on debt is a tax-deductible expense for the firm. Small firms (Canada): tax rate of 20% (approx) Large firms (Canada): tax rate of 34% (approx) the benefit to large corporations of the interest tax shields is greater than the benefit to smaller firms.
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4 Tax Shield: Small vs. Large Firms NO DEBT $5 Million in Debt EBIT $1,000,000 $1,000,000 Interest (10%) 0 500,000 Taxable income 1,000,000 500,000 Tax (20%) 200,000 100,000 Net income 800,000 400,000 TAX SHIELD 0 100,000 NO DEBT $5 Million in Debt EBIT $1,000,000 $1,000,000 Interest (10%) 0 500,000 Taxable income 1,000,000 500,000 Tax (40%) 400,000 200,000 Net income 600,000 300,000 TAX SHIELD 0 200,000 SMALL FIRM BIG FIRM
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5 Sabrina Buti, Rotman School of Management, RSM 333 Short-Term Versus Long-Term Debt Short-term Debt – Maturity of 1 year or less – Typically has a floating rate of interest (interest rate risk!) Long-term Debt – Maturity greater than 1 year – Often borrowed at a fixed rate (no interest rate risk!) Long-term debt is more expensive than short-term debt.
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6 Sabrina Buti, Rotman School of Management, RSM 333
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This note was uploaded on 04/23/2011 for the course RSM 333 taught by Professor Sabrinabutti during the Spring '11 term at University of Toronto- Toronto.

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RSM333 lecture3a - Sources of Financing Outline I. Debt Tax...

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