Criteria for Debt selection

When to increase debt:

• Income tax deductibility of interest expense
• Access to tax-exempt debt

When to take less debt:

• Business Risk
• Less liquidity of assets
 Benefits of Using Debt
Income Tax deductibility of Interest expense
• Cost of Capital

• Tax Shield
Tax Shield or TS = rD * mtr * D
PV(TS) = (rD * mtr * D ) / rD
The firm value = Value of All Equity Firm + PV Tax Shield
 Cost of Debt- Financial Distress
• Causes-
High business risk
High financial risk

• Cost of Financial Distress

Distorted business decisions
Covenants imposed by lenders
High interest rates
• Implications
Trade-off Theory
Bond Yield Rates
 WACC of Hutchison Whampoa for 1995

Debt 0.307882 0.35 0.4 0.45 0.5 0.55 0.6 0.65 0.7 0.75

Equity 0.692118 0.65 0.6 0.55 0.5 0.45 0.4 0.35 0.3 0.25

Ra 0.164551 0.164551 0.164551 0.164551 0.164551 0.164551 0.164551 0.164551 0.164551 0.164551

Re 0.190027 0.195388 0.20273 0.211407 0.22182 0.234546 0.250455 0.270908 0.298179 0.336358

Rd 0.107282 0.107282 0.107282 0.107282 0.107282 0.107282 0.107282 0.107282 0.107282 0.107282

WACC 0.164551 0.164551 0.164551 0.164551 0.164551 0.164551 0.164551 0.164551 0.164551 0.164551

WACC with Income

tax deductibility of
interest expense 0.161204 0.160746 0.160203 0.159659 0.159115 0.158572 0.158028 0.157485 0.156941 0.156398
 0.4

0.35

Ra

0.3

Re

0.25

Rd
0.2

WACC
0.15

WACC with Income tax deductibility of interest

0.1 expense

0.05

0
1 2 3 4 5 6 7 8 9 10
D/A 
0.30 0.50 0.60 0.70