Debt Financing, Firm Value, and the Cost of Capital

23 Pages Posted: 21 Oct 2008

See all articles by Robert S. Harris

Robert S. Harris

University of Virginia - Darden School of Business

Susan Chaplinsky

University of Virginia - Darden School of Business

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Abstract

This note is suitable for an introductory MBA course in corporate finance. It explores how managers determine the proper amount of debt financing to use to fund a firm's operations. It examines the fundamental differences between debt financing and equity financing and the factors that drive the choice between them.

Excerpt

UVA-F-1166

DEBT FINANCING, FIRM VALUE, AND THE COST OF CAPITAL

An important issue facing managers is to what extent a firm should make use of debt financing in funding the firm's operations and investments. To focus on the conceptual issues of how risk and return are altered in firms that make use of debt financing, we initially consider only two funding sources: “plain-vanilla” debt and common equity. While clearly many different kinds of debt exist (e.g., medium term notes, zero-coupon, subordinated, mortgage-backed, convertible), from the perspective of shareholders the specific differences in contract terms are small in relation to the concern that a fixed interest payment is now promised ahead of equity claims. This note explores how managers attempt to determine the proper mix of debt and equity financing for their firms. These target weights—a certain percentage of debt and a certain percentage of equity—are often used to calculate a weighted average cost of capital. The weighted-average cost of capital will also require estimates of the returns investors require on the firm's debt and equity. There is an important “feed-back” mechanism at play between the firm and the capital markets: the return investors demand for holding the firm's securities will depend on the financing used by the firm. Because financing has the potential to affect the cost of capital, it has the potential to affect value creation. Thus, we focus on how the use of debt affects the value of the firm in order to provide a way of thinking and guidance about financing decisions.

. . .

Keywords: Corporate financial strategy, capital structure, debt policy

Suggested Citation

Harris, Robert S. and Chaplinsky, Susan J., Debt Financing, Firm Value, and the Cost of Capital. Darden Case No. UVA-F-1166, Available at SSRN: https://ssrn.com/abstract=1278893

Robert S. Harris (Contact Author)

University of Virginia - Darden School of Business ( email )

P.O. Box 6550
Charlottesville, VA 22906-6550
United States
434-924-4823 (Phone)
434-924-4859 (Fax)

HOME PAGE: http://www.darden.virginia.edu/faculty/harris.htm

Susan J. Chaplinsky

University of Virginia - Darden School of Business ( email )

P.O. Box 6550
Charlottesville, VA 22906-6550
United States
434-924-4810 (Phone)
434-243-7676 (Fax)

HOME PAGE: http://www.darden.virginia.edu/faculty/chaplinsky.htm

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