TOPIC 3: FINANCIAL LEVERAGE AND COST OF CAPITAL
1. 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.
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