Capital structure theory

Financial Leverage and Capital Structure Policy

Capital Structure Theories ,[object Object],[object Object],[object Object],[object Object]

Capital Structure Effects on Value ,[object Object],[object Object],[object Object]

MM entered a theoretical universe where the following conditions existed ,[object Object],[object Object],[object Object],[object Object],[object Object],[object Object],[object Object],[object Object]

MM Proposition 1 with Zero Taxes ,[object Object],[object Object],[object Object]

MM Proposition 2 with Zero Taxes ,[object Object]

WACC depends on Business Risk ,[object Object],[object Object],[object Object],[object Object]

Investors Indifferent ,[object Object],[object Object]

Proposition 2 equation for the levered cost of Equity For a zero-growth company with no taxes, Free Cash Flow to Equity = Net Income = EBIT – Interest Expense From Proposition 1 (1) (2) Substitute (2) into (1) This is the Proposition 2 equation

MM Proposition 2: No taxes Cost of Capital (%) Debt/Value Ratio (%) r s WACC r d r sU

MM Proposition 1 with Taxes ,[object Object],[object Object]

MM Proposition 2 with Taxes ,[object Object]

MM Proposition 2 with Taxes r sL increases with leverage at a slower rate when corporate taxes are considered. The WACC continues to decline as new debt is added. Risk premium now includes (1-T)

Cost of Capital (%) Debt/Value Ratio (%) MM Proposition II: With taxes r s WACC r d (1 - T) r sU

Value of Firm, V (%) Debt V L V U MM relationship between value and debt with taxes TD V U

Trade-off Theory ,[object Object],[object Object],[object Object],[object Object],[object Object],[object Object],[object Object],[object Object],[object Object]

Trade-off Theory (cont.) ,[object Object],[object Object]

Trade-off theory suggests these types of firms will use more debt ,[object Object],[object Object],[object Object],[object Object],[object Object],[object Object],[object Object]

Debt can reduce Equity Agency Costs ,[object Object],[object Object],[object Object],[object Object]

Debt can reduce Equity Agency Costs (cont.) ,[object Object],[object Object],[object Object],[object Object]

Debt can reduce Equity Agency Costs (cont.) ,[object Object],[object Object]

Signaling Theory ,[object Object],[object Object],[object Object],[object Object],[object Object],[object Object]

Signaling theory results in Pecking Order Hypothesis ,[object Object],[object Object],[object Object],[object Object],[object Object],[object Object],Maintain borrowing capacity

Summing the theories ,[object Object],[object Object],[object Object],Capital structure decision requires judgment!

[object Object],[object Object],[object Object],Other factors in setting the target capital structure

Capital structure theory

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Capital structure theory