So far, we have covered two of the six ideas underlying all of corporate finance: net present value (NPV) and the capital asset pricing model (CAPM). The NPV formula has two explicit inputs: the cash flows and the discount rate. The discount rate is given by the CAPM. So far, so good. However, this is not enough. The discount rate is also affected by a third, implicit, input – the amount of debt the firm has. The obvious explanation for this is that investors factor- in the risk that the firm will go bankrupt into their calculations and accordingly pay a lower price (demand higher returns) for a firm with a higher default possibility. Although this is quite true, it is not the entire answer. Investors will pay a lower price even for firms that have no bankruptcy risk if the firm has debt.