429week07f07 - Week 7: Oct 10 WACC Debt w/o Tax Debt w/ Tax...

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Week 7: Oct 10 WACC Debt w/o Tax Debt w/ Tax DCF
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WACC Debt w/o Tax The discount rate for the company is the opportunity cost of capital for the firm. Beta works the same but β debt is usually zero. For equity portion of the firm, use CAPM: debt equity firm R E D D R E D E R WACC + + + = = equity debt equity firm E D E E D D E D E β + + + + = ) - ( equity f m iM f R R R R + = M i iM M iM iM Var Cov σ ρ = =
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WACC We can find Beta by calculating the Cov and Var if the firm is a publicly traded firm for which we can find return information. For the debt portion, check financial statements of estimate cost of debt using credit ratings. Miller and Modigliani I (MMI) “Leverage does not change the value of a firm.” In a world without taxes or bankruptcy costs, the value of the firm is the same with or without debt. Shareholders can offset the value of the debt by taking appropriate borrowing/lending positions themselves.
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Debt is valued as the present value of the flows. If you take debt and commit to pay interest, you receive upfront just enough to make it worth it. You are indifferent. Doing some algebra: (MMII) Hence, if Rul>Rdebt, issue debt to increase return of the firm. Keep in mind, the value of the firm does not change. The return of equity has increased, but so has the risk (and the discount factor for the firm). The net effect is zero. ) ( debt
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This note was uploaded on 04/06/2008 for the course H ADM 429 taught by Professor Cchang during the Fall '03 term at Cornell University (Engineering School).

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429week07f07 - Week 7: Oct 10 WACC Debt w/o Tax Debt w/ Tax...

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