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Unformatted text preview: e amount of the firm’s earnings paid in taxes, thereby making
more earnings available for bondholders and stockholders. The deductibility of
interest means the cost of debt, ki, to the firm is subsidized by the government.
Letting kd equal the before-tax cost of debt and letting T equal the tax rate, from
Chapter 11 (Equation 11.2), we have ki kd (1 T). Probability of Bankruptcy
The chance that a firm will become bankrupt because of an inability to meet its
obligations as they come due depends largely on its level of both business risk and
Business Risk In Chapter 11, we defined business risk as the risk to the firm
of being unable to cover its operating costs. In general, the greater the firm’s operating leverage—the use of fixed operating costs—the higher its business risk.
Although operating leverage is an important factor affecting business risk, two 14. Franco Modigliani and Merton H. Miller, “The Cost of Capital, Corporation Finance, and the Theory of Investment,” American Ec...
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