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Corporate Finance
MBA 8135
Corporate Finance
MBA 8135
Corporate Finance
MBA 8135
Corporate Finance
MBA 8135
Financial Risk
- Additional risk placed on the common stockholders as a result of
debt financing, usually measured by the standard deviation of its
levered RoE minus the standard deviation of its unlevered RoE
Financial Leverage usually leverages up the expected
ROE, but also increases the standard deviation (i.e. also
increases the risk) of the levered RoE
Example:
- Assets = $175,000; EBIT = $35,000; Interest rate = 10%;
- Taxes = 40%, standard deviation of ROE = 8%.
- The company changes the capital structure from 100% equity-financing
to 50% equity and 50% debt.
- Effects on ROE, business risk, financial risk? Tax shield?
Exp.
Exp.
35,000
35,000
8,750
EBT
35,000
26,250
Tax
14,000
10,500
NI
21,000
15,750
EBIT
Interest
RoE
Total expected
return to investors
The use of debt shields a portion of a companys earnings from the tax collector
Corporate Finance
MBA 8135
(FreeCashFlows )t
(1 + WACC )t
t =1
Value =
Hamada Equation
- Increase in debt ratio also increases the risk faced by
shareholders, which can be measured with Beta
Betalevered = Bunlevered 1 + (1 t )
E
Betaunlevered = Betalevered
1
D
1 + (1 t )
E
Corporate Finance
MBA 8135
Example (1)
D/E
k(d)
0.25
0.67
10
1.5
12
15
k(d) a/tax
Beta*
1.2
k(s)**
WACC***
Example (2):
Corporate Finance
MBA 8135
Corporate Finance
MBA 8135
Signaling theory
- A firms decision to use debt or stock to raise new capital gives
a signal to investors