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IMPORTANT:

Let us consider the claim values in a world as proposed by M & M which deals with financial equity and debt only.

  • According to the claims, the probable states of the future are used at the time of partitioning the payoffs.
  • Summation of the various claims ought to be equal to the net value of the projects.
  • The control right and the flow of cash don’t have any role to play as far as the firms current value is concerned.

Each claim comes with a set of risk parameters. As far as any sort of residual claims are concerned, it is nothing but the equity that has been levered. If you consider this option along with compete ownership, you ought to figure out that it is a more risk approach.

Capital COST

  • The capital cost involved rises with the debt amount. If a claim is more risky than another, then the first must come with return rates that are higher as well. This is nothing but a compensation for the extra bit of risk involved. If you compare ownership that is outright and levered equity, the latter’s expected return rate must be higher.

The Big Picture: How to Think of Debt and Equity 47

  • Considering the source of financing of a firm to be either equity or debt or both, the WACC is as mentioned above.
  • The WACC is independent of the manner in which the various projects are financed.
  • The quoted rate may be higher than the return rate of equity that is expected as well as the return rate.

In the event that the ratio of debt of a particular firm is comparatively high and the firm has a considerable amount of property or collateral involved. Then it is for certain that such a debt is free from any form of risk. Under such circumstances, even the rate of return falls. If the capital cost of a firm is ten percent and the rate that is free from risks is five percent, then equity that remains will be:

The Big Picture: How to Think of Debt and Equity 48

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The Big Picture: How to Think of Debt and Equity 49

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