FIN534 W8 D1 n D2

FIN534 W8 D1 n D2 - Risk-Free Debt What is wrong with the...

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Risk-Free Debt What is wrong with the following argument: "If a firm issues debt that is risk free, because there is no possibility of default, the risk of the firm's equity does not change. Therefore, risk-free debt allows the firm to get the benefit of a low cost of capital of debt without raising its cost of capital of equity"? The argument is wrong because it says the firm’s equity does not change. However the firm’s equity will change because the cost of capital of equity and the cost of capital debt are all connected. Whether there is no possibility for default if one of these aspects changes it will cause the rest to changes. Valuation with Leverage With corporate income taxes, explain why a firm's value can be higher with leverage even though its earnings are lower. The firm’s value can be higher with leverage even though its earnings are lower because it now has more debt and this debt allows the company to lower the amount of money they pay taxes on. This leverage makes the company look more valuable even though it may not be. Leverage is when a company takes on debt, which it then invests with the intent of improving the
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FIN534 W8 D1 n D2 - Risk-Free Debt What is wrong with the...

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