In this class, we continued our discussion of the cost of capital approach to optimizing debt ratios by first looking at enhancements to the approach and then at the determinants of the optimal. In particular, it was differences in tax rates, cash flows (as a percent of value) and risk that determined why some companies have high optimal debt ratios and why some have low or no debt capacity. We then looked at the Adjusted Present Value (APV) approach to analyzing the effect of debt. In particular, this approach looks at the primary benefit of debt (taxes) and the primary costs (expected bankruptcy) and netted out the difference from the unlevered firm value. If you are interested in trying this out, I have attached an APV spreadsheet which you can use on your company (with your own judgment call on what the indirect bankruptcy cost is as a percent of value). We closed the discussion of optimal by noting that many firms decide how much to borrow by looking their peer group and argued that if you decide to go this route, you should use more of the information than just the average.
Post Class Test: http://www.stern.nyu.edu/~adamodar/pdfiles/cfovhds/postclass/session19test.pdf
Post Class Test Solution: http://www.stern.nyu.edu/~adamodar/pdfiles/cfovhds/postclass/session19soln.pdf