Accounting Case

1 Value of a firm without debt = 1.2 million / 11%

Cash flow 1,200,000

Value of a firm without debt = 10,909,091

2 Cost of Equity 11%

Cost of Debt 7%

Tax Rate 35%

Equity 8,909,091

Debt 2,000,000

WACC = 81.67% * 11% + (7%*0.65)* 18.33%

WACC = 9.82%

After tax cash flow 1,109,000

Value of a firm with debt = 11,296,155

3 If the interest expense is not tax deductible the

value of the firm is same as calculated in part a.

After tax cash flow 1,060,000

New WACC 10.27%

Value of a firm with debt = 10,324,675

Cost of equity capital 11%

Different Contractual Obligations

Debt:

 An obligation to make periodic, fixed

payments to lenders

 Failure to make timely payments: default

 Default is followed by transfer of control

(ownership) to lenders

Different Contractual Obligations

Equity:

 No obligation to make fixed payments

 Claim on residual cash flows

 Residual cash flow:

 What's left after everyone has been paid

 All claims on the firm's assets have been met

(including future investment needs)

Cost of Debt

 Estimate YTM using most recent bond price

 Example: 5-year 10% coupon bond sells for

$1,100

 Coupons paid semiannually

 YTM = 7.56% (APR)

 EAR = (1+0.0756/2)2 - 1 = 0.0770 = 7.7%

 RD = 7.7%

 Is this the true cost of debt? Taxes?

Raise