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The absence of debt means the absence of financial leverage. Equity in a firm with no debt is therefore called unlevered equity. Because the present
The absence of debt means the absence of financial leverage. Equity in a firm with no debt is therefore called unlevered equity. Because the present value of the equity cash flows is $ you can raise $ by selling all the unlevered equity in your firm. Doing so allows you to keep the NPV of $ as profit after paying the investment cost of $ In other words, the projects NPV represents the value to the initial owner of the firm in this case, the entrepreneur created by the project. As an alternative, you also consider borrowing some of the money you will need to invest. Suppose the businesss cash flow is certain to be at least $ Then you can borrow $ at the current riskfree interest rate of You will be able to pay the debt of $ X $ at the end of the year without any risk of defaulting. How much can you raise selling equity in your business right now? Equity in a firm that also has outstanding debt is called levered equity. After the debt is repaid, equity holders can expect to receive $ What discount rate should we use to value levered equity? What expected return will investors demand? Its tempting to use the same equity cost of capital as before. In that case, by selling levered equity, you could raise $ If this result were correct, then using leverage would allow you to raise a total amount, including the debt, of or more than in the case without leverage. Thus, it would seem that simply financing a project with leverage can make it more valuable. But if this sounds too good to be true, it is Our analysis assumed that your firms equity cost of capital remained unchanged at after adding leverage. The optimal capital structure depends on market imperfections such as taxes, financial distress costs, agency costs, and asymmetric information as follows: Make sure of the interest tax shield if your firm has consistent taxable income. Balance the tax benefits of debt against the costs of financial distress when determining how much of the firms income to shield taxes with leverage. Consider shortterm debt for external financing when agency costs are significant. Increase leverage to signal managers confidence in the firms ability to meet its debt obligations. Investors understand that bankruptcy is costly for managers. Be mindful that investors are aware that you have an incentive to issue securities that you know are overpriced. Rely first on retained earnings, then debt, and finally equity. This pecking order of financing alternatives will be most important when managers are likely to have a great deal of private information regarding the value of the firm. Do not change the firms capital structure unless it departs significantly from the optimal level.
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