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Chapter 16 Overview

Chapter 16 Overview - Chapter 16 Capital Structure Analysis...

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Chapter 16: Capital Structure Analysis We have arrived at one of the most important topics of the course--analyzing how a firm goes about determining its capital structure, i.e. the mix of debt, preferred stock and common equity. Overview. The analysis examines the choice of the capital structure in terms of return and risk, and the associated tradeoffs faced by a risk-averse firm. In this case, "return" refers to maximizing firm value and minimizing WACC, and risk refers to the financial risk (financial leverage) associated with debt. 1 That is, for the corporation, debt has a greater financial risk but a lower (after-tax) cost of capital, while equity has a smaller risk but a greater cost of capital. The starting point of the discussion is to view the total risk of the firm as consisting of two distinct parts, business risk and financial risk. The interaction (in a non-mathematical manner, the "sum of") the business leverage and the financial leverage determine the total leverage of the firm. The business leverage comes solely from operations, and therefore the key variable is EBIT. On the finance side, we take the business leverage as given, and focus on the financial leverage, which increases as the firm takes on more debt. Of course the absolute level of debt is not the key factor, but rather the relative importance of debt in the capital structure. Therefore, the focus will be on the debt/asset ratio (D/A) or the debt/equity ratio (D/E or D/S). 2 However, even though we take the business risk as given we recognize that the firm focuses on total risk, and financial risk will build on the business risk to increase the total risk of the firm. Intuitively (and supported by the empirical evidence), a firm with smaller business risk is more likely to choose greater financial risk (more debt), and a firm with greater business risk is more likely to take on less financial risk (less debt). In analyzing the capital structure, we make two simplifying assumptions. First, we assume the firm does not raise capital with preferred stock. This assumption is used as in the U.S. we observe that preferred stock is a relatively unimportant source of capital. This assumption indicates that the capital structure decision of the firm comes down to a choice between debt (lower cost but riskier) and common equity ("equity), which is less risky but more expensive. Second, we assume that the firm does not have enough retained earnings to fund the entire equity component. Therefore, the marginal equity financing is coming from issuing new common stock. This leads to the key issue that will be analyzed--should the firm raise capital by issuing new debt or using new common equity (retained earnings or new common stock?
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