IRR - Measures annualized rate of return on Investment- Hypothetical discount rate that sets NPV=0; WACC=Hurdle rate (IRR=WACC

⇒ NPV=0; IRR>WACC ⇒ NPV>0; IRR<WACC ⇒

NPV<0 | Perfect market assumptions are violated. – Distortions like Taxes – Bankruptcy costs – Asymmetric information – and agency costs
Capital structure matters becs D & E are taxed differently – Profits are taxed net of interest payments – Interest payments to debtholders are not taxed. –Debt reduces the firm’s tax
expense and increases the cash flow to investors. IMPORTANT: Taxes alone lower the available cashflows; It is tax shield on debt that increases the cashflows; Debt increases firm
value by reducing the tax burden. | Interest Tax Shield: Savings on taxes paid (increase in cash flow to investors) due to the tax deductibility of interest = Taxes Paid by Unlevered
Firm - Taxes paid by levered firm OR Interest Tax Shield = Interest Payment × Corporate Tax rate; Lower corporate taxes result in ↑ cash flows
VL = VU + PV(Annual tax savings due to debt) = VU + PV(rD*D*TC )

WACC = (E/D+E)*(rE) + (D/D+E)*(rD)*(1-Tc) - tax-deductible interest, the effective

cost of capital goes down due ITS. Pay rD*D to debtholders, but get rD*D*TC back
in tax savings- effective (after-tax) cost of debt capital reduces to rD*(1 − Tc)

1. VALUING TAX SHIELD: Constant Debt (i.e. permanent debt or fixed debt schedule- interest tax shield has the same risk as the
debt; – Appropriate discount rate is rD – If debt is permanent/perpetual ⇒ PV(Tax shield) = PV(rD*D*TC ) = rD* D*TC/rD= D*Tc
[AND] Constant/Target D/E OR Dynamic Debt: Firm Value Varies Every year due to changing nature of business operations - So
D needs to adjust to maintain constant debt ratio- interest tax shields is a fraction of firm value, thereby inheriting its risk.
Appropriate discount rate is rU i.e., the expected asset return. – Where rU = pre-tax WACC = (E D+E)*(rE ) + (D/D+E)*(rD )

2. VALUING A FIRM/PROJECT

underlying operations because of cash on balance sheet!

and thecost of levered equity. Equity < risky than
beta and the cost of unlevered equity is > levered beta
Insight: There can be situations in which the unlevered
This is all there is to efficient markets hypothesis:
Current prices reflect expected future value.
Using debt increases firm value but decreases equity value.
How do shareholders benefit? – From the increase in share
price!

Fallacy 2: Although LVI’s expected EPS rises with leverage,

the risk of its EPS also increases. – The increase in EPS is
only to compensate the shareholders for additional risk. –
In other words the share price impact of increase in
earnings is completely offset by the increase in risk leaving
LVI’s share price unchanged.
If you pay more than current price to retire some equity, the
remaining equity value is diluted resulting in a drop in stock Benefits of Debt- Corporate Taxes,
price. Equity would not be diluted if the shares were bought Managerial Agency, Issuance Costs; Costs of
back at the fair price of $10. At a purchase price of $12, those Debt- Agency Costs & Bankruptcy Costs
who sell gain at the expense of those who do not sell.
Debt in a firm’s capital structure leads to the
possibility of ● Financial distress – Difficulty in
meeting debt obligations ● Default – Firm
fails to make the required payment (interest
or principal) on its debt
are a second order consideration
they do play a role in capital structure, but it seems that they
amount of debt. Taxes can be important for many things, and
often negative, that is they often hold more cash than the
Tech firms tend to have the lowest levels of debt. Net debt is
 Economic Distress: Reduction in value of the projects of the firm. – By “value of the
projects” think of the value of the projects as if financed 100% with equity. – Say a drop
in sales due to depressed demand / loss of market share | Financial distress not same
as economic distress – Financial Distress refers to the inability of the firm to meet its
short-term financial obligations – EcD may lead to Financial Distress for a levered firm if
it renders the firm incapable of meeting its debt obligations.
Default under Perfect Capital Markets: MM Irrelevance holds with both financial distress and
default. Decline in value is NOT caused by bankruptcy.● Can happen, say, due to industry or
economic crises ● Independent of whether the firm has leverage | Capital Structure is irrelevant if
financial distress does not alter the total cash flows of the firm ● It merely redistributes firm value
from shareholders to creditors. | When to limit debt to avoid bankruptcy? When there are
additional costs associated with bankruptcy
Net benefit of debt is tax shield minus expected Bankruptcy cost =
bankruptcy costs: VL = VU+PV(interest tax 20M
shields)-Expected bankruptcy costs =
VU+PV(interest tax shields)-p(B) × BC, where
p(B) = probability of bankruptcy, BC = Expected
bankruptcy costs ● Firms with more volatile
cash flows will avoid debt due to potentially
higher risk of default/bankruptcy.

Main Implication: Firm should revert towards a target leverage

ratio when shocks move the firm from it
Agency Conflict: Conflict due to separation of cash flow rights and control rights | Useful : Fund Entrepreneurs affected by cash constraints; Risk Sharing; Specialization-
Financing vs Implementation | When firms issue debt, shareholders have 2 ways to increase cash flows: Increase the “pie” so both shares and bonds benefit OR Expropriate
wealth away from bondholders = conflict (Agency costs of leverage) | Debt financing can distort investment strategy: Firms may forgo +ve NPV projects and invest in -ve NPV
projects; Firms may take on excessive investment or risky projects with -ve NPV - gambling at the expense of debtholders investment; Costs: Underinvestment or
Overinvestment – Firms may siphon off assets to protect it from creditors {Investment distortions are especially costly for high-growth firms}
Debt Overhang and Underinvestment: Too much debt may destroy value because it can cause firms to underinvest in profitable projects- Intuitively, if firms invest, their profits
first service debt- If there is too much debt, little of the increase in profits go to shareholders- If so, shareholders may choose not to invest even if projects are good; they pay
themselves dividends instead- To avoid the incentives to underinvest, firms should avoid excessive debt | Highly levered firm - shareholders have residual cash-flow rights – Weak
incentives to work on behalf of debt holders – Underinvestment and therefore value destruction ● This situation was called debt overhang
Risk-Shifting/Overinvestment: Firms with high debt have incentives to invest in excessively risky projects, sometimes even those with negative NPV | Intuition: With more risk, there is
both more upside and more downside ● More upside ⇒ more benefits to shareholders but more downside does not matter as much – it is still zero! Thus, shareholders of levered
firms have incentives to take on excess risk ● The taste for excess risk due to debt is called “moral hazard” (E.g.: Financial crisis: Investment banks & COVID-19 crisis: Retail borrowers)
Who bears the burden of overinvestment or risk-shifting? With leverage, managers or shareholders may take value-
reducing decisions. Equity holders benefit at the expense of debt holders. Debtholders anticipate perverse incentives. They
demand protection- higher interest rates (higher cost of debt). It raises the bar (hurdle rate) for potential +ve NPV projects.
(Reduces profitable investment opportunities) |-ve impact on stock price/equity value. Shareholders bear the agency costs.
Free cash-flow theory emphasizes the conflict
between shareholders & managers. Managers
squander off cash in wasteful investments &
expenditure. Inefficient investment: vanity projects,
empire building (Increase size of firm ⇒ Increases
CEOs prestige, power and compensation), excessive
diversification (Risk-Averse), buying private jets etc.
● Debt has a disciplinary role: Ties the hand of the
Incentive Conflict/ Corporate governance discount: manager, reduces wasteful expense; Direct discipline –
Market applies a discount to the stock prices of through monitoring; Indirect discipline – pressure to
companies where there are perceived conflicts of meet the interest payments to avoid default ● Debt
interest or governance issues. lowers agency costs of free cash flow (FCF) because it
forces managers to conserve cash to pay interest and
principal. It also imposes market discipline by making
them refinance maturing debt ● Value created by debt
= PV (reduction in wasted FCF)
Debt as a
disciplining Managerial Entrenchment sol.: Incentive Compensation: Linking pay to performance; Corporate Governance: BOD,
mechanism activist investors; Market discipline: Active takeover market to discipline poor performers; Activist Investors

Information gaps: ● Firms know more about their financial condition than outside investors, creating an information gap ●
When firms raise capital, investors wonder why ● Something is wrong with the company ● Shares are overpriced ● Money
raised will be abused ● If info gaps aren’t closed, investors assume the worst and firm value drops ● This problem is worse
with equity, and less so with debt. | Debt as a signal ● Information Asymmetry - Managers know more– Can use debt to
signal information regarding future prospects.
Asymmetric Information and Cost of Equity ● Adverse selection in issuing new equity (Lemon’s problem) – Self-
selection: Overvalued firms will issue equity ● Makes equity issuance very costly. ● Empirical evidence: ● Firms
manipulate earnings using discretionary accounting choices before IPOs and SEOs to improve sale terms. ● Stock market
reacts positively (negatively) to leverage-increasing (reducing) transactions. The pecking order: 1. Internal cash flow 2.
Issue debt. Debt is less sensitive to info gaps b/w insiders and outsiders 3. Issue equity as a last resort ● Implication: High
growth firms will retain cash to fund +Ve NPV investments | Intuition Check: Why IT & Biotech/Pharma Companies
retain more cash? They are high growth firms ⇒ Greater +ve NPV projects – External capital costlier than retained cash⇒
Retain Cash to finance future investments (+VE NPV) Why take on less debt? Debt reduces retained cash – May lead to
underinvestment problem – Debt covenants: Imposes restrictions on investments – Volatile Cash flows⇒ risk of default
(Financial Distress Costs) | Other drivers of financing choices include ● Collateralizability of assets: Nature of industry ●
Behavioral biases of managers due to conservatism, overconfidence, etc
Debt: Secured and unsecured; Pvt: bank loans; public: bonds; Types(by maturity)
Commercial paper: short-term unsecured maturity < 1 year; Short-term bonds: maturity 1-5 years; Medium-term or Intermediate-term
bonds: 5-10 years; Long-term: >10 years; Shorter maturity bonds are associated with lower cost of debt (yields) | Yield: IRR that an
investor gets on a bond- can change over time! BONDS: FV to be repaid at maturity; Tenor- remaining life of bond; Coupon =
Coupon Rate × face Value; Covenants- additional debt restrictions, negative pledges, dividend restrictions, financial ratios maintain, disposal of assets, M&A and capex.
Collateral- specific and general. Firm Value (V)=PV(Expected Free Cash Flows)= FCF1/(1+WACC) + (FCF1(1+g))/ (WACC−g) | Hurdle rate for project = WACC – Lowering Lowest possible
WACC increases the number of +VE NPV projects a firm can undertake!- Basic idea: If leverage cannot alter value, leverage cannot alter the cost of capital either
| βE = βU + (D/E)*(βU − βD) | Note that (D/E) (rU − rD) denotes the additional risk premium equity holders demand for the increased risk that the firm’s leverage
imposes- increase in leverage ratio- Why because: leverage makes good states better and bad states worse, thereby increasing the volatility of return on equity.