# Financial management

Classified in Economy

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**TOPIC 3: FINANCIAL LEVERAGE AND COST OF CAPITAL1. FINANCIAL LEVERAGE: effect on risk and return:**The capital structure that produces the highest firm value is the one that maximizes shareholder wealth.E.G: Trans Am Corporation currently has no

**debt**in its capital structure. The firm is considering issuing debt to buy back some of its equity.

Assets equal equity for this all-equity firm, so return on assets (ROA) is equal to return on equity **(ROE). ROA=EBIT/ASSETS. **

**ROE=EBIT-Rb*B/S**

Earnings per share (EPS) depends on the earnings of each scenario as EPS=Earnings/#shares outstanding

**Probability of solvency: **Based on the estimate distribution of EBIT, you may estimate the probability of solvency for a given amount of debt defined as:

**Prob (EBIT > Interest expenses)**

**2. THE COST OF DEBT**

Cost of debt refers to the effective rate a company pays on its current debt or on the new debt issuance.It adjusts for the **tax** deductibility of interest expense.The **cost** of debt is easier to estimate than the cost of equity. For bonds with a small risk of defaulting, the current yield to maturity is a good estimate of investor expected returns and the cost of borrowing.

The after-tax cost of debt can be written as:

**After − tax cos cos of debt = (1 − tax rate) ·Borrowing rate**

**Why is tax-adjusted the cost of debt while we do not tax-adjust the cost of equity?** Because firms candeduct their interest payments before paying taxes but dividends are not tax deductible.The bank is asking for a price (interest rate) for which the amount lent equals the present value of the payments received from the borrower: **Co=∑pj/(1+Rb)^j.**But ‘i’ is not the Bank’s IRR on the loan nor the cost of the debt to the borrower, because there are also fees charged to the borrower: screening fees, transaction costs or specific taxes (in mortgages).Therefore the cost of the debt to the borrower is computed by solvingRBin:**Co-fees=Io=∑Pj/(1+Rb)^j**