Wacc And Firm Value As A Function Of Leverage

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WACC -*-Firm Value

While this illustration makes the choice of an optimal financing mix seem trivial, it obscures some real problems that may arise in its applications. First, an analyst typically does not have the benefit of having the entire schedule of costs of financing prior to an analysis. In most cases, the only level of debt about which there is any certainty about the cost of financing is the current level. Second, the analysis assumes implicitly that the level of cash flows to the firm is unaffected by the financing mix of the firm and, consequently, by the default risk (or bond rating) for the firm. While this may be reasonable in some cases, it might not in others. For instance, a firm that manufactures consumer durables (cars, televisions etc.) might find that its sales drop if its default risk increases because investors are reluctant to buy its products.

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