### ...about the visualization

A fundamental decision facing financial managers is the financing of a firm's activities. There are 2 sources of funds: debt financing or selling bonds, and equity financing or selling stock. Two important considerations face the manager:

- Financial decisions have tax implications. Payments made to bondholders to service the firm's debt are made with pre-tax dollars. Stock dividends are paid from after-tax income.
- The amount of debt versus equity financing may influence the investors' desire to buy the firm's securities. As leverage increases, the expected risk and return of the firm's stick will increase as will the expected loss due to bankruptcy.

Since the manager's job is to maximize the value of the firm we expect her to finance the firm's activities using the mix of debt and equity financing which results in the lowest cost of capital to the firm. Other things being equal, we expect debt financing to be less expensive than equity financing because of the tax implications. We also expect an increase in in debt financing to increase the cost of equity financing because of the effect of financial leverage on the risk of the firm's stock.

### ...about the visual program The axes' labels: rE....The return on the firm's equity. In other words, the price the firm pays to attract investors to purchase its stock. rD....The return on the firm's debt. In other words, the price paid to bondholders. r*....The Weighted Average Cost of Capital You can vary the corporate tax rate and debt:equity ratio in order see how taxes and changes in financing strategy will affect the cost of capital and thus, the decisions made by managers. As the corporate tax rate increases, managers will be more likely to use debt financing other things being equal. The plane represents the set of points we might expect to occur. Note that in the real world, a firm's bonds almost always pay less than its stock. Therefore the visual program removes situations in which rD > rE by marking them invalid. |

### ...about the conversion to web page

Select Pick mode in the Execution panel. Then by clicking on the cost-of-capital plane, you will see values at that point on the plane.

[ Java Explorer | IBM home page | Order | Search | Contact IBM | Help | (C) | (TM) ]