Debt financing does affect the financial risk of the

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Debt financing does affect the financial risk of the firm Additional risk concentrated on common stockholders when debt financing is used 16-9
How Leverage Affects ROE Borrowing magnifies ROE Higher highs, lower lows This is not a source of value to shareholders Shareholders can replicate a firm’s borrowing on their own if they choose Homemade leverage 16- 10
Case A: MM’s Proposition I Assumptions of all of MM’s arguments: “Well functioning” capital markets: firms and investors can borrow at the same rate Efficient capital markets Assumptions of Case A: No taxes No costs of financial distress 16- 11
Case A: MM’s Proposition I Proposition I: The value of a firm does not depend on its capital structure Cash flows of a firm are not affected by changes in capital structure 16- 12
Case A: MM’s Proposition I 16- 13 Example: A firm currently has no debt and 1 million shares outstanding, with a price of $10 per share. It considers a restructuring that would issue $4 million in debt to repurchase 400,000 shares. How does this affect firm value? Before Restructuring: After Restructuring:
Case A: MM’s Proposition II Proposition II: A firm’s cost of equity (requity) increases as leverage increases However, this increase does not affect the value of the firm 16- 14
Case A: MM’s Proposition II 16- 15 Where: rassets: expected return on the firm’s assets rdebt: expected return on the firm’s debt (cost of debt) requity: expected return on the firm’s equity (cost of equity) D: market value of debt E: market value of equity V: total firm value (D + E)
Debt and the Cost of Equity: Example 16- 16 A firm’s cost of debt is 9%, and its expected return on assets is 14%. The firm is financed with $3 million debt and $7 million equity. What is the firm’s cost of equity?
Debt and the Cost of Equity In Case A, the increase in requity is exactly offset by the decrease in E/V 16- 17
MM Case B: Debt and Taxes Debt financing advantage: the interest that a firm pays on debt is tax-deductible Interest tax shield: Where: Tc: tax rate rdebt: debt interest rate (assume price=par) D: debt outstanding 16- 18
Perpetual Tax Shield If this tax shield is perpetual, then: 16- 19

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