Answer:
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Answer: Yes, borrowing creates value for equity shareholders. This is mainly as a result of tax benefits of interests paid on borrowings
Explanation:
Yes, borrowing does create value for the equity shareholders, this is mainly as a result of tax benefit of interests paid on borrowings.
If leverage causes changes, then it should lead to changes in either the discount rate of the firm(which is weighted-average cost of capital) or changes in the cash flows of the firm.
Leverage causes changes in both discount rate (WACC) and not on the cash flows to the firm. Since, WACC is known as the weighted average of cost of debt and cost of equity and since the cost of debt is usually less than the cost of equity, the WACC decreases with increase in borrowings, when the equity beta does not change. Furthermore, as the cash flows to firm is calculated before the interests paid on borrowings, the increased borrowings wont affect the Value of asset (FCFF) .
Cash flow is discounted at the rate that is consistent with the risk of those cash flow. At the cost of capital for the unlevered firm, pure businesses should be discounted. Financing flow needs to be discounted at the rate of return required by the provider of debts.
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