Capital Structure

# Capital Structure - Capital Structure Define Capital...

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1 Capital Structure Define Capital Structure • The mix of debt and equity financing used for the firm’s assets. Hi h f l i th fi th t • Hierarchy of claims on the firm says that debt holders get paid before equity holders. • More debt holders means more likelihood that the equity holders will get less or nothing, making their claim more risky. • More new debt holders also means that existing debt holder’s claims become more risky.

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2 Implications of Rising Debt Levels • Equity holders’ claims become more risky as debt financing increases, so the cost of it i equity rises. • Debt holders’ claims also become more risky as debt financing increases, so the cost of debt also rises. Viewpoints on Capital Structure It doesn’t matter • It doesn t matter. • Firms should use 100% debt • Some capital structure between 0 and 100% is optimal
3 The “It Doesn’t Matter” Viewpoint • First advocated by Modigliani and Miller in 1958. Viewed by many as the beginning of modern finance theory. • Requires a world of perfect markets to be correct. The MM Position • Assumed a no tax world. • If firm has no debt, all of EBIT goes to equity holders. • With debt, EBIT is split between debt and equity holders. • Cost of capital is a weighted average with the weights being market value ratios of debt to assets and equity to assets.

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4 Changing the Weights in the WACC : is WACC the world, tax no a In A E w A D w e d = = 8% ( 6)(10 ( 4)(5 WACC then 40%, to increases w if but 9% (.8)(10) (.2)(5) WACC 80% w and 20% w if 10%, K and 5% K if example, For WACC. the lower will weight) its g (increasin debt cost low more adding equity, than cost lower a has debt since constant, are K
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## This note was uploaded on 02/24/2010 for the course FINA 4310 taught by Professor Impson during the Spring '10 term at North Texas.

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Capital Structure - Capital Structure Define Capital...

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