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Learning objectives:
After going through optimal capital structure theories, modifications
made in them, applicability of these theories, impact of debt on value of
firm and WACC, different principles to decide about capital structure
and different approaches to WACC calculation now we study the
management of capital structure:
Traditionalist Theory - Effect of Capital Structure on Firm Value &
Share Price:
As 100% Equity Firm Takes On More and More Debt (or Leverage):
Cost of Capital decreases (cost of debt is cheaper than equity), reaches a
minimum point, and then rises (excessive debt increases financial risk).
Total Market Value of Firm (V = D + E = Market Value of Debt +
Market Value of Equity) first rises (because of Interest Tax Shield
savings), then reaches a maximum point (optimal capital structure), and
finally falls (because of excessive fall in Net Income and Equity value
because of interest payments).
Share Price (Po= Total Value / Original Number of Shares OR Equity
value / Number of Shares Outstanding) first rises, then reaches
maximum (same point as maximum Value), and finally falls. Follows
same shape as Total Market Value of Firm. Share Price is a measure of
Firm Value.
Traditionalist Theory - Effect of Capital Structure on Earnings and
Risk:
As 100% Equity Firm Replaces More and More Equity with Debt (or
Leverage): Mean (or Expected) EBIT assumed to be unchanged
although excessive debt can cause it to rise because of higher operational
costs because of financial distress. Mean EBT will fall because interest
payments rise.
Mean Net Income (or Earnings) generally falls continuously because
interest payments rise faster than any interest tax savings.
Mean Earnings Per Share (EPS = Net Income / Number of Shares
outstanding) generally first rises if number of shares falls if Equity is
Firms with (1) solid assets that can be mortgaged as security against a
loan and (2) stable sales and Operating Leverage can generally use debt
more safely.
High Tax Bracket Firms: such firms have greater advantage in using
debt because of large Interest Tax Shield Savings.