A theory of the firm's cost of capital : how debt affects the firm's risk, value, tax rate, and the government's tax claim

The cost of capital concept has myriad applications in business decision-making. The standard methodology for deriving cost of capital estimates is based on the seminal Modigliani-Miller analyses. This book generalizes this framework to include non-debt tax shields (e.g., depreciation), interactions between the borrowing rate and tax shields, and default considerations. It develops several new results and shows how better cost of capital and marginal tax rate estimates can be generated. The book's unified cost of capital theory is discussed with comprehensive numerical examples and graphical illustrations. This book will be of interest to corporate managers, academics, investment bankers, governmental agencies, and private companies that generate cost of capital estimates for public consumption. Contents......Page 10 Preface......Page 6 List of Figures......Page 12 List of Tables......Page 14 I. Introduction......Page 16 II. Model Setting......Page 20 III. Distributional Assumptions......Page 34 Step 1. The Relevant Tax States......Page 38 Step 2. Determine the Par Yield......Page 42 Step 4. Determine Expected Rates of Return and Market Values......Page 44 The Borrowing Rate Determines the Firm’s Tax Obligations......Page 48 Risk of the Tax Shields and the Firm’s Claims......Page 49 The Marginal Effects of Borrowing on Firm Risk and the WACC......Page 51 The Marginal Effects of Debt on Firm Value......Page 54 Debt Capacity......Page 55 The “Three Claims View” of the Firm......Page 56 The Value of the Tax Claim......Page 57 Effective MTR......Page 58 VI. Extension to s × s states......Page 60 VII. Numerical Illustration......Page 62 VIII. Conclusion......Page 72 A.1 Sign of NPVA......Page 78 A.3 Debt Capacity......Page 79 A.4 For an NPVA > 0 Firm at Debt Capacity, VT > 0......Page 82 A.5 Sensitivity of Bi and βi to an Increase in Φ i......Page 83 Examples Illustrating the Firm’s Balance Sheet Using the Data in Table 8......Page 92 References......Page 100 Index......Page 104 Contents 10 Preface 6 List of Figures 12 List of Tables 14 I. Introduction 16 II. Model Setting 20 III. Distributional Assumptions 34 IV. Model Solution Procedure 38 Step 1. The Relevant Tax States 38 Step 2. Determine the Par Yield 42 Step 3. Determine the Risks of the Tax Shields and the Claims 44 Step 4. Determine Expected Rates of Return and Market Values 44 V. Discussion of Results 48 The Borrowing Rate Determines the Firm’s Tax Obligations 48 The Cost of Risky Debt 49 Risk of the Tax Shields and the Firm’s Claims 49 The WACC 51 The Marginal Effects of Borrowing on Firm Risk and the WACC 51 The Marginal Effects of Debt on Firm Value 54 Debt Capacity 55 The “Three Claims View” of the Firm 56 The Value of the Tax Claim 57 Effective MTR 58 VI. Extension to s × s states 60 VII. Numerical Illustration 62 VIII. Conclusion 72 Appendix A 78 Discussion of Various Results 78 A.1 Sign of NPVA 78 A.2 The Par Yield is Non-Decreasing in D 79 A.3 Debt Capacity 79 A.4 For an NPVA > 0 Firm at Debt Capacity, VT > 0 82 A.5 Sensitivity of Bi and βi to an Increase in Φ i 83 Appendix B 92 Examples Illustrating the Firm’s Balance Sheet Using the Data in Table 8 92 References 100 Index 104 The cost of capital concept is widely used in business decision-making. The current theory and estimates for measurement of cost of capital are derived from the seminal Modigliani-Miller analyses. This book generalizes this framework to include non-debt tax shields (e.g., depreciation) and default considerations. It develops several new results and shows how better cost of capital and marginal tax rate estimates can be generated. The unified cost of capital theory presented in the book is illustrated graphically and with comprehensive numerical examples. This book will be of great interest to practicing managers, academics, governmental agencies and private companies that generate cost of capital estimates for public consumption Ramesh K.s. Rao, Eric C. Stevens. Includes Bibliographical References (p. 85-88) And Index.