CAPITAL STRUCTURE

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CAPITAL STRUCTURE

• THEORY AND PRACTICE

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CAPITAL STRUCTURE

• Investment, Financing, and the Black Box Model
• Key Issues
• Is there an optimal capital structure?
• If so, what is it?
• Definitions
• Optimal Capital Structure
• the debt-equity mix that simultaneously
• minimizes the cost of capital
• maximizes the value of the common stock
• maximizes firm value

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CAPITAL STRUCTURE

• Capital Structure Building the Model
• MM Case I
• Perfect markets
• No taxes
• No bankruptcy costs (how?)
• No agency costs (how?)
• Information symmetry
• Equal access to capital markets
• Result Proposition I Firm value is invariant
  to capital structure.
• VL VU

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CAPITAL STRUCTURE

• MM Case II
• Perfect markets
• Corporate taxes (Tc gt 0)
• No bankruptcy costs
• No agency costs
• Information symmetry
• Equal access to capital markets
• Result Firm value is increased by borrowing,
  due to the associated reduction in the
  firms tax liability.
• VL VU TcD

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CAPITAL STRUCTURE

• MM Case III
• Perfect markets
• Corporate taxes (Tc gt 0)
• Nontrivial bankruptcy and agency costs
• Information symmetry
• Equal access to capital markets
• Result Every dollar of debt increases firm
  value by reducing firm tax liability, but
  decreases firm value by increasing the expected
  value of bankruptcy and/or agency costs.
• VL VU TcD - PV E(BRC) - PV E(AC)

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CAPITAL STRUCTURE

• Bankruptcy costs examples
• Agency costs examples
• Just plain M
• What do decision-makers really do?

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CAPITAL STRUCTURE

• Real-world determinants of capital structure
• Marginal tax rates
• Non-debt tax shields
• Nature of the firms assets
• Earnings uncertainty/level of business risk
• Capital market conditions
• One more theory a financial pecking order