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The idea is to value the project as if it were all equity financed ("unleveraged"), and to then add the present value of the tax shield of debt – and other side effects. [2] Technically, an APV valuation model looks similar to a standard DCF model. However, instead of WACC, cash flows would be discounted at the unlevered cost of equity, and ...
Among other things, the value of Ke and the Cost of Debt (COD) [6] enables management to arbitrate different forms of short and long term financing for various types of expenditures. Ke applies most prominently to companies that regularly generate excess capital (free cash flow, cash on hand) from ongoing operations.
This tax-related encouragement of debt financing has not gone uncriticized. [2] For example, some critics have argued that the cost of equity should also be deductible; which could reduce the Internal Revenue Code's influence on capital-structure decisions, potentially reducing the economic instability attributable to excessive debt financing. [2]
Trade-off theory of capital structure allows bankruptcy cost to exist as an offset to the benefit of using debt as tax shield. It states that there is an advantage to financing with debt, namely, the tax benefits of debt and that there is a cost of financing with debt the bankruptcy costs and the financial distress costs of debt. [24]
Under this assumption, the value of the tax shield is: (interest bearing debt) x (tax rate). Using the above examples: Assume Case A brings after-tax income of $80 per year, forever. Assume Case B brings after-tax income of $144 per year, forever. Value of firm = after-tax income / (return of capital), therefore
c = cost of capital, or the weighted average cost of capital (WACC). NOPAT is profits derived from a company's operations after cash taxes but before financing costs and non-cash bookkeeping entries. It is the total pool of profits available to provide a cash return to those who provide capital to the firm.
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The cost of capital is the return expected from investors for bearing the risk that the projected cash flows of an investment deviate from expectations. It is said that for investments in which future cash flows are incrementally less certain, rational investors require incrementally higher rates of return as compensation for bearing higher ...