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Unformatted text preview: CHAPTER 16 Planning the Firm's Financing Mix CHAPTER ORIENTATION This chapter concentrates on the way the firm arranges its sources of funds. The cost of capital capital structure argument is highlighted. A moderate view on the effect of financial leverage use on the composite cost of capital is adopted. Later, techniques useful to the financial officer faced with the determination of an appropriate financing mix are described. CHAPTER OUTLINE I. Introduction A. A distinction between financial structure and capital structure 1. Financial structure is the mix of items on the right-hand side of the firm's balance sheet. 2. Capital structure is the mix of long-term sources of funds. 3. The main focus will be capital structure management and not the appropriate maturity composition of the sources of funds. B. The objective of capital structure management is to mix the permanent sources of funds in a manner that will maximize the company's common stock price. This proper mix of fund sources is referred to as the optimal capital structure. II. A glance at capital structure theory A. The cost of capital capital structure argument may be characterized by this question: Can the firm affect its overall cost of funds by varying the mixture of financing sources used? B. If the firm's cost of capital can be affected by the degree to which it uses financial leverage, then capital structure management is important. 136 C. The analytical discussion revolves around a simplified version of the basic dividend valuation model. 1. It assumes (a) cash dividends paid will not change over the infinite holding period, and (b) the firm retains none of its current earnings. 2. The analytical setting for the discussion of capital structure theory assumes (a) corporate income is not subject to any taxation, (b) capital structures consist of only stocks and bonds, (c) the expected values of all investors' forecasts of the future levels of net operating income for each firm are identical, and (d) securities are traded in perfect or efficient financial markets. III. Extreme position 1: The Independence Hypothesis (NOI Theory) A. When business income is not subject to taxation, the firm's composite cost of capital and common stock price are both independent of the degree to which the firm chooses to use financial leverage. B. Total market value of the firm's outstanding securities is unaffected by the arrangement of the right-hand side of the balance sheet. C. The independence hypothesis rests upon what is called the net operating income (NOI) approach to valuation . D. The use of a greater degree of financial leverage may result in greater earnings and dividends, but the firm's cost of common equity will rise at precisely the same rate as the earnings and dividends....
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This note was uploaded on 07/29/2011 for the course FIN 202 taught by Professor Hung during the Spring '11 term at Keuka.
- Spring '11