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The goal of the capital structure decision is to
determine the financial leverage that maximizes the value of the company (or minimizes the weighted average cost of capital)
In the Modigliani and Miller (MM) theory developed without taxes
MM 1 (no taxes)
The deductibility of interest _____ (decrease/increase) the cost of debt and the cost of capital for the company as a whole
Lowers
Adding the tax shield provided by debt to the MM framework suggests
that the optimal capital structure is all debt
MM Proposition II (No Taxes) says
that increasing the use of cheaper debt financing serves to increase the cost of equity, resulting in a zero net change in the company’s WACC. Again, capital structure is irrelevant
MM Proposition I (With Taxes)
the tax deductibility of interest payments creates a tax shield that adds value to the firm, and the optimal capital structure is achieved with 100% debt i.e. VL = VU + (t*d)
MM Proposition II (With Taxes) says
that WACC is minimized at 100% debt
Costs of financial distress
Increased costs companies face when earnings decline and the company has trouble paying its fixed costs
Higher amounts of leverage result in ____ (lower/greater) expected costs of financial distress
greater
The net agency costs of equity
the costs associated with the conflict of interest between a company’s managers and owners
Three components of the net agency costs of equity
Monitoring costs. Bonding costs. Residual losses
Costs of asymmetric information result from
managers having more information about a firm than investors
Cost of asymmetric information increases as more ____ (debt/equity) is used in capital structure
equity
Pecking order theory states that
managers prefer financing choices that send the least visible signal to investors, with internal capital being most preferred, debt being next, and raising equity externally the least preferred method of financing
The static trade-off theory
recognizes that there are tax benefits associated with issuing debt because interest expense is tax deductible, but increasing the use of debt also increases the cost of financial distress. At some point, the cost of fin. distress will exceed the tax benefit of debt. This point represents the optimal capital structure
Expression - static trade off theory
VL=VU + (t*d) - PV(cost of financial distress)
At the optimal target capital structure
the incremental tax shield benefit is exactly offset by the incremental costs of financial distress
When there are bankruptcy costs, a high debt ratio _____(increases/decreases) the risk of bankruptcy
increases
Using _____ (less/more) debt in a company’s capital structure reduces the net agency costs of equity
more
Good corporate governance and accounting transparency should (decrease/increase) the net agency costs of equity
Decrease
The target capital structure
is the structure that the firm uses over time when making capital structure decisions
The actual capital structure will fluctuate around the target due to
management’s exploitation of market opportunities and market value fluctuations
Factors an analyst should consider when evaluating a firm’s capital structure include
1) Changes in the firm’s capital structure over time 2) Capital structure of competitors with similar business risk. 3) Factors affecting agency costs such as the quality of corporate governance
___ analysis tool is useful to determine whether management\'s current capital structure policy is maximizing the value of the firm
Scenario analysis
Major factors that influence international differences in financial leverage include
Institutional, legal, and taxation factors - strength of legal system, information asymmetry, taxes. Financial market and banking system factors - liquidity of capital markets, reliance on banking system, institutional investor presence. Macroeconomic factors - inflation and GDP
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