This chapter discusses various theories of capital structure and how it relates to the value of the firm and cost of capital. It outlines the Modigliani-Miller view that capital structure does not affect firm value versus the traditional view that moderate debt can lower costs. It also discusses how interest tax shields, bankruptcy costs, and agency costs factor into the optimal capital structure based on a trade-off theory. The chapter further examines pecking order theory and approaches for establishing an appropriate capital structure including cash flow analysis.

1. Chapter - 15 Capital Structure Theory and Policy

8. Arbitrage

9. Arbitrage

11. MM Propositions I and II

14. MM Hypothesis with Corporate Tax

17. Miller’s Approach with Corporate and Personal Taxes

18. Demand rate of interest Supply rate of interest Borrowing i s = i o /(1 – T c ) i d = i o /(1 – T b ) %

23. Financial Distress Debt Market Value of The Firm Value of unlevered firm PV of interest tax shields Costs of financial distress Value of levered firm Optimal amount of debt Maximum value of firm