RSM333H1 Lecture Notes - Lecture 10: Capital Structure, Tax Shield, Cash Flow
Document Summary
Firm has offer to convert all variable costs to fixed. Firm replaces half of equity with debt, where kd is half of ke. As debt increases, wacc decreases because debt costs lest than equity. As debt increases, degree of total leverage increases because of higher fixed costs from interest. Management has control at point of issue and repurchase. Firm cannot control debt to equity ratio because value of equity of firm changes. Financial leverage reflects how roe varies with changes in roi. Effect of using debt as source of capital. Roi cares about total investment, not source of investment. Roe=roi + difference between roi and cost of debt. Roe = direct return + return from debt that each dollar of equity supports. Roe = roi + distribution effect of debt + tax shield (indirect effect) Tax shield is benefit equity holders receive because there is leverage. Easy for firms to earn more than after-tax cost of debt.
