Capital Structure Concepts

Capital Structure Concepts - Capital Structure Concepts...

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Capital Structure Concepts Capital structure is the relative amount of permanent short-term debt, long-term debt, preferred stock, and common stock used to finance the firm. This lecture summarizes some basic concepts and theories of capital structure. I. Capital structure is one of the fundamental topics in financial management. Some important terms are: A. Capital structure --the relative amounts of permanent short-term debt, long-term debt, preferred stock, and common stock used to finance a firm. B. Financial structure --the relative amounts of total current liabilities, long-term debt, preferred stock, and common stock used to finance a firm. C. Optimal capital structure -- the capital structure that minimizes a firm's weighted cost of capital and, therefore, maximizes the value of the firm. D. Target capital structure -- the capital structure at which the firm plans to operate. E. Debt capacity -- the amount of debt in the firm's optimal capital structure. F. The optimal capital structure (and debt capacity) is determined by factors including: the business risk of the firm, the tax structure, bankruptcy potential, agency costs, and signaling effects. II. The discussion of capital structure is based on important assumptions. A. Assume that the firm's investment policy is held constant. The capital structure changes the distribution of the firm's operating income (EBIT) among the firm's claimants, including debtholders, preferred stockholders, and common stockholders. B. With a constant investment policy, investments are assumed to leave the debt capacity of the firm unchanged. III. Business risk is the variability or uncertainty of a firm's operating income (EBIT). A. A firm's business risk is influenced by many factors, including: 1
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the variability of sales volume; the variability of selling prices; the variability of costs; the degree of market power (the absence of present or future competition reduces the firm's risk); the extent of product diversification; the firm's growth rate; and the degree of operating leverage (DOL). Operating leverage involves the use of assets having fixed costs. The DOL is defined as the percentage change in EBIT resulting from a given percentage change in sales. B. Business risk has elements of both systematic risk and unsystematic risk. Some of the variability of operating income that results from business risk can be diversified away (the unsystematic portion) and some of the variability cannot be diversified away (the systematic part). IV.
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This note was uploaded on 04/20/2011 for the course FIN 4181 taught by Professor Spencer during the Spring '11 term at Dowling.

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Capital Structure Concepts - Capital Structure Concepts...

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