The purpose of this paper is to instruct upper level business students on the intricacies of the debt‐equity choice with the emphasis on showing the interrelation of this choice with the plowback‐payout choice.
The paper is designed around a pedagogical exercise that applies academic theories on the computation of the gain to leverage for an unleveraged nongrowth firm. A question and answer methodology is used within the exercise. The approach is instructional as it attempts to teach students about firm valuation and the variables that are important in the valuation process. The firm valuation method is based on perpetuity equations with and without growth.
Unlike an empirical study that concentrates on providing findings from a data analysis, this paper attempts to instill knowledge and skills to students when making debt‐equity and plowback‐payout choices.
All gain to leverage equations used in this paper are limited by their derivational assumptions and the estimation of values for variables used in the equations.
Besides using the traditional Modigliani and Miller (MM)‐Miller gain to leverage equations, this paper also uses more recent gain to leverage equations that attempt to bridge the gap between theory and practice by applying new theory on the impact of the plowback‐payout choice on the debt‐equity choice. Students will be able to compare traditional and recent gain to leverage equations and form their own opinions as to their potential value in practice. In the process, they should get an idea of the practical complexities of financial decision‐making.
Optimizing firm value through proper decision‐making implies there is a proper and efficient utilization of societal resources.
The paper builds on a prior pedagogical paper that incorporated discount rates (costs of borrowing) within the nongrowth MM‐Miller gain to leverage framework. This paper's originality and value lies in being the first pedagogical paper to incorporate growth as determined by the plowback‐payout decision within the nongrowth gain to leverage framework.
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