Many factors determine how much debt a firm takes on. Among the main factors include the effect of debt on firms’ value: Corporate Finance Assignment, UM, Malaysia


Universiti Malaya (UM)

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Corporate Finance

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  • Many factors determine how much debt a firm takes on.  Among the main factors include the effect of debt on firms’ value. Does borrowing create value?  If not, then why do so many executives concern themselves with leverage? If leverage affects value, then it should cause changes in either the discount rate of the firm (i.e., its weighted-average cost of capital) or the cash flows of the firm. Refer to Exhibit 1a and fill in the empty cell. How does the value of an asset change? Explain in your written report.
  • In finance, as in accounting, the two sides of the balance sheet must be equal.  In the previous problem, we valued the asset side of the balance sheet.  To value the other side, we must value the debt and the equity, and then add them together. Referring to, as the firm levers up, how does the increase in value get apportioned between creditors and shareholders? Explain in your written reports
  • In the preceding problem, we divided the value of all the assets between two classes of investors that are creditors and shareholders.  This process tells us where the change in value is going, but it sheds little light on where the change is coming from.  Let’s divide the free cash flows of the firm into pure business flows and cash flows resulting from financing effects.  Now, an axiom in Finance is that you should discount cash flows at a rate consistent with the risk of those cash flows.

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