Product Overview

This exercise leads students through the essential logic linking capital structure and firm value. It begins with a nontax benchmark, then proceeds through valuations with tax deductibility based on (1) a discount rate with tax effects built in (discount free cash flow at the WACC), (2) the valuation of specific claims (value equity cash flows and debt cash flows separately), and (3) the valuation of types of cash flow (value assets and interest tax shields separately). These concepts are linked to stock price effects around recapitalizations, and financial risk (leverage effects on CAPM betas) is also introduced and illustrated.

Learning Objectives

# Introduce a number of valuation frameworks. # Familiarize students with the idea that the benefit of debt financing arises from the tax shield provided by interest payments. # Examine the effect of debt on equity cash flow volatility. # Teach students to leverage and unleverage beta.