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06/05/06
Capital structure
The issues that we seek to address in this chapter are:
How does a firm select its capital structure (debt-equity ratio)? Is there an optimal capital structure?
Considerations:
Financial leverage and its effect on firm value Theories that may explain capital raising decisions
Pecking order theory Miller and Modigliani (M&M) theories Static theory of Finance
therefore this would represent the highest cost of borrowing from the firms perspective.
Financial leverage
Financial leverage refers to the extent to which a firm
relies on debt financing. The more debt a firm uses, relative to equity, the more financial leverage it employs.
(EPS).
Financial leverage
The breakeven earnings before interest and taxes (breakeven
are indifferent between the amount of debt and equity in its capital structure.
EBIT) is the level of earnings at which the firm and its owners
1. Internal funds are cheapest to use (no issuance costs) and require no private information release.
2. Debt financing is cheaper than equity financing.
proposition suggests that the cost of equity (Re) is a function of three things: the required return on the firms assets (WACC or RA), the cost of debt and the debt-equity ratio:
WACC = RA Rd
where VE is the value of an all-equity firm and tc is the corporate tax rate and TC * D represents the tax shield.
becomes more risky, i.e., will have a higher chance of defaulting on its debt and investors will therefore demand a higher return.
Rd
Rd
V($)