The document discusses capital structure, which is the mix of debt and equity used to finance a firm. The value of a firm is equal to the value of its debt plus the value of its equity. The optimal capital structure maximizes firm value by balancing the debt-equity ratio. Factors that influence the capital structure decision include business risk, taxes, financial flexibility, growth opportunities, and market conditions. Leverage increases risk for shareholders but also increases potential returns, as interest payments are tax deductible. Higher debt leads to greater financial risk.
2. 2
Definition: Capital Structure is the mix of financial
securities used to finance the firm.
The value of a firm is defined to be the sum of the value
of the firm’s debt and the firm’s equity.
V = B + S
If the goal of the management of the firm is to make the
firm as valuable as possible, then the firm should pick the
debt-equity ratio that makes the pie as big as possible.
Value of the FirmBS
3. Business Risk
Company Tax exposure
Financial Flexibility
Management Style
Growth Rate
Market Condition
Cost of Fixed Assets
Size of Business Organization
Nature of business Organization
Elasticity of Capital Structure
4. Net Income Approach (NI)
Net Operating Income Approach (NOI)
Traditional Approach (TA)
Modigliani and Miller Approach (MM)
5. Need to consider two kinds of risk:
◦ Business risk
◦ Financial risk
6. Standard measure is beta (controlling for financial
risk)
Factors:
◦ Demand variability
◦ Sales price variability
◦ Input cost variability
◦ Ability to develop new products
◦ Foreign exchange exposure
◦ Operating leverage (fixed vs variable costs)
7. The additional risk placed on the common
stockholders as a result of the decision to finance
with debt
8. If the same firm is now capitalized with 50% debt
and 50% equity – with five people investing in debt
and five investing in equity
The 5 who put up the equity will have to bear all
the business risk, so the common stock will be
twice as risky as it would have been had the firm
been all-equity (unlevered).
9. Financial leverage concentrates the firm’s
business risk on the shareholders because debt-
holders, who receive fixed interest payments, bear
none of the business risk.
10. Leverage increases shareholder risk
Leverage also increases the return on equity (to
compensate for the higher risk)
11. Interest is tax deductible (lowers the effective cost
of debt)
Debt-holders are limited to a fixed return – so
stockholders do not have to share profits if the
business does exceptionally well
Debt holders do not have voting rights
12. Higher debt ratios lead to greater risk and higher
required interest rates (to compensate for the
additional risk)
Previous chapters discuss the capital budgeting decisions. Chapter 15&16 focus on the right hand side of the balance sheet model – capital structure.
