Introduction to Corporate Finance

Ross et al.: Fundamentals

of Corporate Finance, Sixth

Edition, Alternate Edition

VI. Cost of Capital and

Long−Term Financial

Policy

17. Financial Leverage and
    Capital Structure Policy

(^608) © The McGraw−Hill
Companies, 2002



$7,000

The value of the levered firm, VL, is:

VLVUTCD

$7,000 .30 1,000

$7,300

As Figure 17.4 indicates, the value of the firm goes up by $.30 for every $1 in debt.

In other words, the NPVper dollarof debt is $.30. It is difficult to imagine why any cor-

poration would not borrow to the absolute maximum under these circumstances.

The result of our analysis in this section is the realization that, once we include taxes,

capital structure definitely matters. However, we immediately reach the illogical con-

clusion that the optimal capital structure is 100 percent debt.

Taxes, the WACC, and Proposition II

The conclusion that the best capital structure is 100 percent debt also can be reached by

examining the weighted average cost of capital. From our previous chapter, we know

that, once we consider the effect of taxes, the WACC is:

WACC (E/V) RE(D/V) RD(1 
TC)

$700

.10

CHAPTER 17 Financial Leverage and Capital Structure Policy 581

FIGURE 17.4

Value of

the firm

(VL)

Total debt

(D)

VL = VU + TC D

VU

 T (^) C
TC  D
VU
1,000
VU $7,000
VL  $7,300
The value of the firm increases as total debt increases because of the interest tax shield.
This is the basis of M&M Proposition I with taxes.
Slide17.24 M&M Proposition I With Taxes