Chapter 17-Capital Structure Determination.ppt

Chapter 17 of capital structure

1. 17.1 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Chapter 17Chapter 17
Capital Structure Capital Structure
DeterminationDetermination

2. 17.2 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
After Studying Chapter 17, After Studying Chapter 17,
you should be able to:you should be able to:
1.Define “capital structure.”
2.Explain the net operating income (NOI) approach to capital
structure and valuation of a firm; and, calculate a firm's value
using this approach.
3.Explain the traditional approach to capital structure and the
valuation of a firm.
4.Discuss the relationship between financial leverage and the cost
of capital as originally set forth by Modigliani and Miller (M&M)
and evaluate their arguments.
5.Describe various market imperfections and other "real world"
factors that tend to dilute M&M’s original position.
6.Present a number of reasonable arguments for believing that an
optimal capital structure exists in theory.
7.Explain how financial structure changes can be used for
financial signaling purposes, and give some examples.

3. 17.3 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
•A Conceptual Look
•The Total-Value Principle
•Presence of Market Imperfections and
Incentive Issues
•The Effect of Taxes
•Taxes and Market Imperfections
Combined
•Financial Signaling
Capital Structure Capital Structure
DeterminationDetermination

4. 17.4 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
•Concerned with the effect of capital market
decisions on security prices.
•Assume: (1) investment and asset management
decisions are held constant and (2) consider
only debt-versus-equity financing.
Capital Structure Capital Structure -- The mix (or proportion) of -- The mix (or proportion) of
a firm’s permanent long-term financing a firm’s permanent long-term financing
represented by debt, preferred stock, and represented by debt, preferred stock, and
common stock equity.common stock equity.
Capital StructureCapital Structure

5. 17.5 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
kk
ii = the yield on the company’s debt = the yield on the company’s debt
Annual interest on debt
Market value of debt
I
B
==kk
ii
Assumptions:
•Interest paid each and every year
•Bond life is infinite
•Results in the valuation of a perpetual
bond
•No taxes (Note: allows us to focus on just
capital structure issues.)
A Conceptual Look –A Conceptual Look –
Relevant Rates of ReturnRelevant Rates of Return

6. 17.6 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
E
S
==
kk
ee = the expected return on the company’s equity = the expected return on the company’s equity
Earnings available to Earnings available to
common shareholderscommon shareholders
Market value of common Market value of common
stock outstandingstock outstanding
kk
ee
Assumptions:
•Earnings are not expected to grow
•100% dividend payout
•Results in the valuation of a perpetuity
•Appropriate in this case for illustrating the
theory of the firm
E
S
A Conceptual Look –A Conceptual Look –
Relevant Rates of ReturnRelevant Rates of Return

7. 17.7 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
O
V
==
kk
oo = an overall capitalization rate for the firm = an overall capitalization rate for the firm
Net operating income
Total market value of the firmkk
oo
Assumptions:
•V = B + S = total market value of the firm
•O = I + E = net operating income = interest
paid plus earnings available to common
shareholders
O
V
A Conceptual Look –A Conceptual Look –
Relevant Rates of ReturnRelevant Rates of Return

8. 17.8 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Capitalization Rate, kCapitalization Rate, k
oo – The discount rate
used to determine the present value of a
stream of expected cash flows.
kk
oo kk
eekk
ii
B
B + S
S
B + S
= +
What happens to kk
ii, kk
ee, and kk
oo
when leverage, B/S, increases?
Capitalization RateCapitalization Rate

9. 17.9 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Assume:
•Net operating income equals $1,350
•Market value of debt is $1,800 at 10% interest
•Overall capitalization rate is 15%
Net Operating Income Approach Net Operating Income Approach – A theory of – A theory of
capital structure in which the weighted average capital structure in which the weighted average
cost of capital and the total value of the firm cost of capital and the total value of the firm
remain constant as financial leverage is changed.remain constant as financial leverage is changed.
Net Operating Net Operating
Income ApproachIncome Approach

10. 17.10 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Total firm valueTotal firm value= O / k
o= $1,350$1,350 / 0.15
= $9,000$9,000
Market value = V – B= $9,000$9,000 – $1,800$1,800 of
equity = $7,200$7,200
Required returnRequired return= E / S on on
equityequity* = ($1,350$1,350 – $180$180) / $7,200$7,200
= 16.25%16.25%
Calculating the required rate of return on equityCalculating the required rate of return on equity
* B / S = $1,800 / $7,200 = 0.25
Interest paymentsInterest payments
= $1,800 × 10%= $1,800 × 10%
Required Rate of Required Rate of
Return on EquityReturn on Equity

11. 17.11 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Total firm valueTotal firm value= O / k
o= $1,350$1,350 / 0.15
= $9,000$9,000
Market value = V – B= $9,000$9,000 – $3,000$3,000 of
equity = $6,000$6,000
Required returnRequired return= E / S on on
equityequity* = ($1,350$1,350 - $300$300) / $6,000$6,000
= 17.50%17.50%
What is the rate of return on equity if B=$3,000?What is the rate of return on equity if B=$3,000?
* B / S = $3,000 / $6,000 = 0.50
Interest paymentsInterest payments
= $3,000 × 10%= $3,000 × 10%
Required Rate of Required Rate of
Return on EquityReturn on Equity

12. 17.12 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
B / S kk
ii kk
ee k k
o o
0.00 —— 15.00%15.00% 15% 15%
0.25 10%10% 16.25%16.25% 15% 15%
0.50 10%10% 17.50%17.50% 15% 15%
1.00 10%10% 20.00%20.00% 15% 15%
2.00 10%10% 25.00%25.00% 15% 15%
Examine a variety of different debt-to-equity Examine a variety of different debt-to-equity
ratios and the resulting required rate of ratios and the resulting required rate of
return on equity.return on equity.
Calculated in slides 9 and 10
Required Rate of Required Rate of
Return on EquityReturn on Equity

13. 17.13 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Capital costs and the NOI approach in a Capital costs and the NOI approach in a
graphical representation.graphical representation.
0 0.25 0.50 0.75 1.0 1.25 1.50 1.75 2.0
Financial Leverage (B/S)
0.25
0.20
0.150.15
0.100.10
0.05
0
C
a
p
i
t
a
l

C
o
s
t
s

(
%
)
kk
ee = 16.25% and = 16.25% and
17.5% respectively17.5% respectively
kk
ii (Yield on debt) (Yield on debt)
kk
o o (Capitalization rate)(Capitalization rate)
kk
e e (Required return on equity)(Required return on equity)
Required Rate of Required Rate of
Return on EquityReturn on Equity

14. 17.14 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
NOI Approach
You can create
this type of
analysis in
Excel also. You
can use some
modeling
experience to
write formulas
to calculate the
required rates.
Refer to “VW13E-
17.xlsx” on the ‘NOI
Approach’ tab
Excel & the NOI ApproachExcel & the NOI Approach

15. 17.15 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
•Critical assumption is k
o remains
constant.
•An increase in cheaper debt funds is
exactly offset by an increase in the
required rate of return on equity.
•As long as k
i
is constant, k
e
is a linear
function of the debt-to-equity ratio.
•Thus, there is no one optimal capital no one optimal capital
structurestructure.
Summary of NOI ApproachSummary of NOI Approach

16. 17.16 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Optimal Capital Structure Optimal Capital Structure – The capital structure
that minimizes the firm’s cost of capital and
thereby maximizes the value of the firm.
Traditional Approach Traditional Approach – A theory of capital
structure in which there exists an optimal capital optimal capital
structure structure and where management can increase
the total value of the firm through the judicious
use of financial leverage.
Traditional ApproachTraditional Approach

17. 17.17 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Traditional ApproachTraditional Approach
Financial Leverage (B / S)
0.25
0.20
0.150.15
0.100.10
0.05
0
C
a
p
i
t
a
l

C
o
s
t
s

(
%
)
kk
ii
kk
oo
kk
ee
Optimal Capital StructureOptimal Capital Structure
Optimal Capital Structure: Optimal Capital Structure:
Traditional Approach Traditional Approach

18. 17.18 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Traditional
Approach
You can create this
type of analysis in
Excel also. We use
some assumptions
in this model built
into the formulas.
Refer to “VW13E-
17.xlsx” on the
‘Traditional
Approach’ tab
Excel and the Excel and the
Traditional ApproachTraditional Approach

19. 17.19 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
•The cost of capital is dependent on the capital
structure of the firm.
•Initially, low-cost debt is not rising and replaces more
expensive equity financing and k
o declines.
•Then, increasing financial leverage and the
associated increase in k
e and k
i more than offsets
the benefits of lower cost debt financing.
•Thus, there is one optimal capital structureone optimal capital structure
where k
o is at its lowest point.
•This is also the point where the firm’s total
value will be the largest (discounting at k
o).
Summary of the Summary of the
Traditional ApproachTraditional Approach

20. 17.20 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
•Advocate that the relationship between
financial leverage and the cost of capital is
explained by the NOI approach.
•Provide behavioral justification for a constant
k
o over the entire range of financial leverage
possibilities.
•Total risk for all security holders of the firm is
not altered by the capital structure.
•Therefore, the total value of the firm is not
altered by the firm’s financing mix.
Total Value Principle: Total Value Principle:
Modigliani and Miller (M&M)Modigliani and Miller (M&M)

21. 17.21 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Market value
of debt ($65M)
Market value
of equity ($35M)
Total firm market
value ($100M)
•M&M assume an absence of taxes and market
imperfections.
•Investors can substitute personal for corporate
financial leverage.
Market value
of debt ($35M)
Market value
of equity ($65M)
Total firm market
value ($100M)
•Total market value is not altered by the capital
structure (the total size of the pies are the same).
Total Value Principle: Total Value Principle:
Modigliani and MillerModigliani and Miller

22. 17.22 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Arbitrage Arbitrage – Finding two assets that are – Finding two assets that are
essentially the same and buying the essentially the same and buying the
cheaper and selling the more expensive.cheaper and selling the more expensive.
Two firms that are alike in every respect
EXCEPTEXCEPT capital structure MUSTMUST have
the same market value.
Otherwise, arbitragearbitrage is possible.
Arbitrage and Total Arbitrage and Total
Market Value of the FirmMarket Value of the Firm

23. 17.23 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Consider two firms that are identical
in every respect EXCEPTEXCEPT:
•Company NL – no financial leverage
•Company L – $30,000 of 12% debt
•Market value of debt for Company L equals its
par value
•Required return on equity
– Company NL is 15%
– Company L is 16%
•NOI for each firm is $10,000
Arbitrage ExampleArbitrage Example

24. 17.24 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Earnings available to Earnings available to = EE= O – I
common shareholderscommon shareholders = $10,000$10,000 - $0
= $10,000$10,000
Market valueMarket value = E / k
e
of of
equityequity = $10,000$10,000 / 0 .15
= $66,667$66,667
Total market valueTotal market value = $66,667$66,667 + $0
= $66,667$66,667
Overall capitalization rateOverall capitalization rate= 15%15%
Debt-to-equity ratio = 0
Valuation of Company NLValuation of Company NL
Arbitrage Example: Arbitrage Example:
Company NLCompany NL

25. 17.25 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Earnings available to Earnings available to = EE= O – I
common shareholderscommon shareholders = $10,000$10,000 – $3,600
= $6,400$6,400
Market valueMarket value = E / k
e
of of
equityequity = $6,400$6,400 / 0.16
= $40,000$40,000
Total market valueTotal market value = $40,000$40,000 + $30,000
= $70,000$70,000
Overall capitalization rateOverall capitalization rate= 14.3%14.3%
Debt-to-equity ratio = 0.75
Valuation of Company LValuation of Company L
Arbitrage Example: Arbitrage Example:
Company LCompany L

26. 17.26 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Assume you own 1% of the stock of
Company L (equity value = $400).
You should:
•1.Sell the stock in Company L for $400.
•2.Borrow $300 at 12% interest (equals 1%
of debt for Company L).
•3.Buy 1% of the stock in Company NL for
$666.67. This leaves you with $33.33 for other
investments ($400 + $300 - $666.67).
Completing an Completing an
Arbitrage TransactionArbitrage Transaction

27. 17.27 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Original return on investment in Company LOriginal return on investment in Company L
$400 × 16% = $64
Return on investment after the transaction
•$666.67 × 15% = $100 return on Company NL$100 return on Company NL
•$300 × 12% = $36 interest paid$36 interest paid
•$64 net return $64 net return ($100$100 – $36$36) AND $33.33 left over$33.33 left over.
This reduces the required net investment to
$366.67 to earn $64.
Completing an Completing an
Arbitrage TransactionArbitrage Transaction

28. 17.28 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
•The equity share price in Company NL rises
based on increased share demand.
•The equity share price in Company L falls based
on selling pressures.
•Arbitrage continues until total firm values are
identical for companies NL and L.
•Therefore, all capital structures are equally as Therefore, all capital structures are equally as
acceptable.acceptable.
•The investor uses “personal” rather than
corporate financial leverage.
Summary of the Summary of the
Arbitrage TransactionArbitrage Transaction

29. 17.29 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
•Agency costs (Slide 17–31)
•Debt and the incentive to manage
efficiently
•Institutional restrictions
•Transaction costs
•Bankruptcy costs (Slide 17–30)
Market Imperfections Market Imperfections
and Incentive Issuesand Incentive Issues

30. 17.30 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Financial Leverage (B / S)
RR
ff
R
e
q
u
i
r
e
d

R
a
t
e

o
f

R
e
t
u
r
n
o
n

E
q
u
i
t
y

(
k
e
)
kk
e e with no leveragewith no leverage
kk
ee without bankruptcy costs without bankruptcy costs
kk
ee with bankruptcy costs with bankruptcy costs
PremiumPremium
for financialfor financial
riskrisk
PremiumPremium
for businessfor business
riskrisk
Risk-freeRisk-free
raterate
Required Rate of Return Required Rate of Return
on Equity with Bankruptcyon Equity with Bankruptcy

31. 17.31 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
•Monitoring includes bonding of agents, auditing
financial statements, and explicitly restricting
management decisions or actions.
•Costs are borne by shareholders (Jensen & Meckling).
•Monitoring costs, like bankruptcy costs, tend to rise at
an increasing rate with financial leverage.
Agency Costs Agency Costs -- Costs associated with monitoring -- Costs associated with monitoring
management to ensure that it behaves in ways management to ensure that it behaves in ways
consistent with the firm’s contractual agreements consistent with the firm’s contractual agreements
with creditors and shareholders.with creditors and shareholders.
Agency CostsAgency Costs

32. 17.32 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Consider two identical firms EXCEPTEXCEPT:
•Company ND – no debt, 16% required return
•Company D – $5,000 of 12% debt
•Corporate tax rate is 40% for each company
•NOI for each firm is $2,000
The judicious use of financial leverage financial leverage
(i.e., debt) (i.e., debt) provides a favorable impact
on a company’s total valuation.
Example of the Effects Example of the Effects
of Corporate Taxesof Corporate Taxes

33. 17.33 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Earnings available to Earnings available to = EE= OO – I
common shareholderscommon shareholders = $2,000$2,000 –
$0 = $2,000$2,000
Tax Rate Tax Rate (TT) = 40%40%
Income available toIncome available to = EACSEACS (1 – TT)
common shareholderscommon shareholders = $2,000$2,000 (1 – 0.40.4)
= $1,200$1,200
Total income available toTotal income available to= EATEAT + I all all
security holderssecurity holders= $1,200$1,200 + 0
= $1,200$1,200
Valuation of Company NDValuation of Company ND (Note: has no debt)
Corporate Tax Example: Corporate Tax Example:
Company NDCompany ND

34. 17.34 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Earnings available to Earnings available to = EE= OO – I
common shareholderscommon shareholders = $2,000$2,000 – $600=
$1,400$1,400
Tax Rate Tax Rate (TT)= 40%40%
Income available toIncome available to= EACSEACS (1 – TT) common common
shareholdersshareholders = $1,400$1,400 (1 – 0.40.4) = $840$840
Total income available toTotal income available to= EATEAT + Iall all
security holderssecurity holders= $840$840 + $600 = $1,440$1,440*
Valuation of Company DValuation of Company D (Note: has some debt)
* $240 annual tax-shield benefit of debt (i.e., $1,440 - $1,200)
Corporate Tax Example: Corporate Tax Example:
Company DCompany D

35. 17.35 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Tax Shield Tax Shield – A tax-deductible expense. The – A tax-deductible expense. The
expense protects (shields) an equivalent dollar expense protects (shields) an equivalent dollar
amount of revenue from being taxed by reducing amount of revenue from being taxed by reducing
taxable income.taxable income.
Present value ofPresent value of
tax-shield benefitstax-shield benefits
of debtof debt*
=
(rr) (BB) (tt
cc
)
rr
= (BB) (tt
cc)
* Permanent debt, so treated as a perpetuity
** Alternatively, $240 annual tax shield / 0.12 = $2,000, where
$240=$600 Interest expense × 0.40 tax rate.
=($5,000$5,000) (0.40.4) = $2,000$2,000**
Tax-Shield BenefitsTax-Shield Benefits

36. 17.36 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Value of unlevered firm Value of unlevered firm = $1,200 / 0.16
(Company ND)(Company ND) = $7,500$7,500*
Value of levered firm Value of levered firm = $7,500$7,500 +
$2,000$2,000 (Company D)(Company D) = $9,500$9,500
Value ofValue of Value ofValue of Present value Present value
ofof
leveredlevered = firm iffirm if+ tax-shield tax-shield
benefitsbenefits
firmfirm unleveredunlevered of debtof debt
* Assuming zero growth and 100% dividend payout
Value of the Levered FirmValue of the Levered Firm

37. 17.37 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
•The greater the financial leverage, the lower the
cost of capital of the firm.
•The adjusted M&M proposition suggests an
optimal strategy is to take on the maximum take on the maximum
amount of financial leverageamount of financial leverage.
•This implies a capital structure of almost 100% This implies a capital structure of almost 100%
debt! debt! Yet, this is notnot consistent with actual
behavior.
•The greater the amount of debt, the greater the tax-
shield benefits and the greater the value of the
firm.
Summary of Summary of
Corporate Tax EffectsCorporate Tax Effects

38. 17.38 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
•Corporate plus personal taxesCorporate plus personal taxes
Personal taxes reduce the corporate tax
advantage associated with debt.
Only a small portion of the explanation why
corporate debt usage is not near 100%.
•Uncertainty of tax-shield benefitsUncertainty of tax-shield benefits
Uncertainty increases the possibility of
bankruptcy and liquidation, which reduces
the value of the tax shield.
Other Tax IssuesOther Tax Issues

39. 17.39 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
As financial leverage increases, tax-shield tax-shield
benefits benefits increase as do bankruptcy and bankruptcy and
agency costsagency costs.
Value of levered firmValue of levered firm
= Value ofValue of firm iffirm if unlevered unlevered
+ Present value of tax-shield benefits Present value of tax-shield benefits
of debt of debt
- Present value ofPresent value of bankruptcy and bankruptcy and
agency costs agency costs
Bankruptcy Costs, Bankruptcy Costs,
Agency Costs, and TaxesAgency Costs, and Taxes

40. 17.40 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Optimal Financial LeverageOptimal Financial Leverage
Taxes, bankruptcy, andTaxes, bankruptcy, and
agency costs combinedagency costs combined
Net tax effectNet tax effect
Financial Leverage (B/S)
C
o
s
t

o
f

C
a
p
i
t
a
l

(
%
)
Minimum Cost
of Capital Point
Bankruptcy Costs, Bankruptcy Costs,
Agency Costs, and TaxesAgency Costs, and Taxes

41. 17.41 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
•Informational Asymmetry is based on the idea that
insiders (managers) know something about the firm
that outsiders (security holders) do not.
•Changing the capital structure to include more debt
conveys that the firm’s stock price is undervaluedconveys that the firm’s stock price is undervalued.
•This is a valid signal valid signal because of the possibility of
bankruptcy.
•A manager may use capital structure changes to
convey information about the profitability and risk
of the firm.
Financial SignalingFinancial Signaling

42. 17.42 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
2.Flexibility
•A decision today impacts the options open to the firm for
future financing options – thereby reducing flexibility.
•Often referred to unused debt capacity.
1.Timing
•After appropriate capital structure determined it is still
difficult to decide when to issue debt or equity and in
what order
•Factors considered include the current and expected
health of the firm and market conditions.
Timing and FlexibilityTiming and Flexibility

43. 17.43 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
•Taxes
•Explicit cost
•Cash-flow ability to
service debt
•Agency costs and
incentive issues
•Financial signaling
•EBIT-EPS
analysis
•Capital structure
ratios
•Security rating
•Timing
•Flexibility
Checklist of Practical and Checklist of Practical and
Conceptual ConsiderationsConceptual Considerations