Mini Case: 16 - 12 Debt holders have a prior claim on cash flows relative to stockholders. Debt holders’ “fixed” claim increases risk of stockholders’ “residual” claim, so the cost of stock, r s , goes up. Firm’s can deduct interest expenses. This reduces the taxes paid, frees up more cash for payments to investors, and reduces after-tax cost of debt Debt increases the risk of bankruptcy, causing pre-tax cost of debt, r d , to increase. Adding debt increase the percent of firm financed with low-cost debt (w d ) and decreases the percent financed with high-cost equity (w ce ). The net effect on WACC is uncertain, since some of these effects tend to increase WACC and some tend to decrease WACC. Additional debt can affect FCF. The additional debt increases the probability of bankruptcy. The direct costs of financial distress are legal fees, “fire” sales, etc. The indirect costs are lost customers, reductions in productivity of managers and line workers, reductions in credit (i.e., accounts payable) offered by suppliers.
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