The cost of debt financing results from 1 the

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Unformatted text preview: (3) the costs associated with managers having more information about the firm’s prospects than do investors. Tax Benefits Allowing firms to deduct interest payments on debt when calculating taxable income reduces the 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 10 (Equation 10.2), 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 financial risk. 10. Franco Modigliani and Merton H. Miller, “The Cost of Capital, Corporation Finance, and the Theory of Investment,” American Economic Review (June 1958), pp. 261–297. 11. Perfect-market assumptions include (1) no taxes, (2) no brokerage or flotation costs for securities, (3) symmetrical information—investors and managers have...
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