tax effect of debt and WACC

Question 1

what are the different costs of capital within the firm?

Answer 1

K_o: cost of operating capital, risk is determine by the dispersoin of possibl4 opereating return

K_d: cost of debt, a function of operating risk and financial leverage

K_e: depends on operating risk, financial leverage, and bankruptcy costs

Question 2

what is optimal financial leverage?

Answer 2

leverage which maximixes GW to equity

or equity PER SHARE (absolute value of equity is not relevant)

Question 3

debt and EV

Answer 3

when debt is introduced, the value distributable to shareholders increases by the value of tax shields

formula: D_nom*t

EV_lev = EV_unl + TS - E[BC]

Question 4

how do you determine WACC?

Answer 4

1. build up with K_e and K_d
2. APV or “build up” method: starts from K_d and computes levered EV, from which it is possible to derive WACC using FCFO

Question 5

APV formula

Answer 5

EV_lev = EV_unl + TS - E[BC]

Question 6

3 rules of cash flow estimation

Answer 6

1. operations under normal conditions
2. purified from extraordinary and non-recurring items
3. growth rate sustainable over time

Question 7

EV_unl formula

Answer 7

EV_unl=[FCFO*(1+g)]/(K_o-g)

Question 8

what is K_o

Answer 8

unlevered cost of capital

K_o=riskfree rate + B_asset*MRP

Question 9

how to compute E[BC]

Answer 9

E[BC]= PD*PV[BC]