Capital Structure Essay

1212 words - 5 pages

In 1958, Franco Modigliani and Merton Miller revolutionized the whole area of corporate finance with their article “The cost of capital, corporate finance and the theory of investment”. Before Modigliani’s and Miller’s article, literature on the topic mainly focused on descriptions of methods and institutions. Theoretical analysis was very rare (Pagano 2008). Under the assumption of perfect capital markets, the Modigliani-Miller Proposition I states that “the average cost of capital to any firm is completely independent of its capital structure and is equal the capitalization rate of a pure equity stream of its class” (Modigliani, Miller 1958). In Proposition II, Modigliani and Miller argue ...view middle of the document...

As the existence of taxation and bankruptcy costs imply that the market is not perfect, Modigliani-Millers Proposition I doesn’t hold any more and there is an optimal capital structure for each company that maximizes firm value.
The tax advantage of debt arises as interest expenses are tax deductable. Under the assumption that the firm’s earnings are large enough, “financial leverage decreases the firm’s corporate income tax liability and increases it’s after tax operating earnings” (Kraus, Litzenberger 1973). The value of this tax shield in one period equals T_C*r_D*D, where Tc is the marginal corporate tax rate, rD is the cost of debt and D stands for the market value of debt. The present value of all future tax shields therefore is:
PV(DITS)=(T_C*r_D*D)/r_D =T_C*D.
Since the after-tax return on debt is (1-T_C ) r_D, the after-tax weighted average cost of capital becomes:
after tax WACC=E/(D+E) r_E+D/(D+E)(1-T_C)r_D.

Source: Berk and DeMarzo (2007)

This implies that the firm value increases linearly with the debt ratio at a rate of (1+T_C).
However, there are costs associated with debt. The costs of debt consist of financial distress and bankruptcy costs. A company is in financial distress if it has difficulties in meeting its debt obligations. When leverage increases, the probability of bankruptcy increases too, leading to higher expected costs of financial distress.

Source: Maug (2010)

The costs of financial distress are incurred by the bondholders in case of bankruptcy. But in markets with rationale investors, the bondholders anticipate these costs and demand compensation for them, thus demanding higher interest rates. Therefore, the equity holders ultimately bare the deadweight costs of financial distress.
These costs can be divided into direct and indirect cost. The direct costs consist mainly of legal and administrative fees. According to Warner (1977), the average direct costs lie between 3-8% of the market value. As most of these costs are fixed, the proportion is much higher for smaller companies.
Indirect costs are potentially much more significant and substantial. They result from suboptimal behaviours of corporate stakeholders. Senbet and Sewart (1995) state “inter- or intra-group conflicts of interest, asymmetric information, free-rider problems, lost sales and competitive position, higher operating costs and ineffective use of management's time” as the main reasons for indirect bankruptcy costs. Andrade and Kaplan (1998) estimate that these indirect costs can make up to 20% of the pre-distressed market value.
The tradeoff...

Other Essays Like Capital Structure

Financial Ratios, Growth Analysis, Cost of Capital, Capital Structure, & Capital Budgeting Analysis for Starbucks Corp

1706 words - 7 pages Running head: Financial Analysis of Starbucks University of Houston-Victoria School of Business Administration FIN6352 – Financial Management Dr. Omar M. Al Nasser August 11th, 2013 Financial Ratios, Growth Analysis, Cost of Capital, Capital Structure, & Capital Budgeting Analysis For Starbucks Corp. Table of Contents Executive Summary……….………………………………………………………….………..3 Capital

Capital Structure (D/E) Differs Substantially From One Company/Industry To Another. Can Theories Of Capital Structure Shed Light On This?

1052 words - 5 pages Capital structure refers to the proportion of financing from debt and from equity capital (D/E ratio). An efficient mixture of capital reduces the price of capital. Lowering the cost of capital increases net economic returns, which, ultimately, increases firm value. There are a number of theories that explain capital structure, namely, M&M, Static Trade-off Theory and the Pecking Order Theory.M&M theory assumes that the market is in a

Report On Capital Structure And The Cost Of Capital Of Astrazeneca Plc And British American Tobacco Plc

2868 words - 12 pages Report on Capital Structure and the Cost of Capital of AstraZeneca Plc and British American Tobacco Plc. Table of Contents 1.0 Introduction………………………………………… 4 2.0 Background………………………………………… 5 3.0 Capital Structure…………………………………… 6 3.1 Debt to equity……………………………… 6 3.2 Long term debt to equity…………………... 7 3.3 Total debt to capital………………………… 7 3.4 Long term debt to

The Optimal Capital Structure According to the Static Trade- Off Theory

2581 words - 11 pages Page |1 Research Paper - The Optimal Capital Structure According to the Static Trade- Off Theory Unit 6 – Research Paper Submitted by Kinjal Mistry Submitted to Dr. Ole Ruankaew California Intercontinental University Dated: 9th Oct-14 Page |2 Research Paper - The Optimal Capital Structure According to the Static Trade- Off Theory Table of Content Introduction of the Optimal Capital Structure According to the Static Trade- Off Theory

Owners Equity

906 words - 4 pages reporting the company’s financial status using earned capital reveals the financial value to the stakeholders. When using the paid-in capital to report the company’s financial status, the company is not implying they are experiencing good investment opportunities. Basic versus Diluted EPS A simple capital structure uses the basic earnings per share, but one problem with the basic EPS is that it does not recognize the potential impact of a

Case Study Pizza Palace

1029 words - 5 pages Case Study: PizzaPalace’s Capital Structure Made by A. C a. Provide a brief overview of capital structure effects. Be sure to identify the ways in which capital structure can affect the weighted average cost of capital and free cash flows. The capital structure decision change the value of the firm either through the the free cash flow or the cost of capital. V = ∑ ∞ t=1 FCFt (1 + WACC)t With

Weighted Average Cost of Capital

762 words - 4 pages methodology. Include at least one graph or chart in your presentation. Company Information The capital structure for the firm will be maintained and is now 10% preferred stock, 30% debt, and 60% new common stock. No retained earnings are available. The marginal tax rate for the firm is 40%. a) Coogly has outstanding preferred stock That pays a dividend of $4 per share and sells for $82 per share, with a floatation cost of $6 per share. What

American Home Product

1038 words - 5 pages  Tayal  (2011141)                                          Section  C   C o r p o r a t e   F i n a n c e -­‐   I I       P a g e  |  2   4 2 0 EPS DPS Current 30% 50% 70% A ns. 4: It is recommended to have 70% debt capital structure as: rom $3.18 to $3.49 (Exhibit 3). It will increase DPS from current level of $1.90 to $2.10. maximization of wealth for them. taxable income, so less Corporate Tax. RO It will

Risk Free Interest Rate

1108 words - 5 pages capital structure refers to the desired optimal mix of debt and equity financing that most firms attempt to achieve and maintain. B. COST OF LONG-TERM DEBT Definitions • Net proceeds : Funds received from the sale of a security (e.g. bond) – Incur two types of costs: flotation and discount • Flotation costs : issuing and selling a security – Apply to all public offerings of securities (debt, preferred and common

A Snapshot on Marginal Risk Contributions

2477 words - 10 pages aggregated loss volatility, and m × ARCPi will be the capital allocation to facility i. Since all ARCPi are stabilizer, they aggregate for any subgroup of facilities, by customer, business units or any other criteria. Since all ARCPi are post-diversification effects, they embed more information than the allocation according to the facility standalone risks, which do not include the correlation structure of facilities. Chapter ending questions

Capital Budjeting

1760 words - 8 pages , replacement machinery, new plants, new products, and research development projects are worth the funding of cash through the firm's capitalization structure (debt, equity or retained earnings). Planning the eventual returns on investments in machinery, real estate and new technology are all examples of capital budgeting. Management must allocate the firm's limited resources between competing opportunities (projects), which is one of the main focuses

Related Papers

Capital Structure Essay

5512 words - 23 pages debenture is a document that either creates a debt or acknowledges it, and it is a debt without collateral. In corporate finance, the term is used for a medium- to long-term debt instrument used by large companies to borrow money. the money raised by the debentures becomes a part of the company’s capital structure,but it does not become share capital Features of debentures Debenture holders are not the owners of the company. They are considered

Capital Structure And Information Asymmetry Essay

3521 words - 15 pages This paper will discuss the choice of capital structure in markets where there is information asymmetry. Particular reference is made to how debt is used as a signalling tool along with a discussion on debt maturity structure. The pecking order theory is examined. Finally this paper reveals empirical evidence of capital structure. Arnold Musadziruma 210525268 Clint Kruger 209541568 Kemsley Grantham 209538112 i “Seminar 4- Capital structure

Capital Budget Structure For Aes Essay

1258 words - 6 pages differing risk levels across markets, it’s quite apparent AES must make a change to its capital budgeting structure, if it is to survive. Q.2 If Venerus and AES implement the suggested methodology, the projects would change drastically due to a change in WACC. To find WACC we must first calculate the leveraged betas for each the US Red Oak and Lal Plr Pakistan projects, the equation unleveled beta/1-(debt to capital) will be used. The

Org Capital Structure And Cash Managment Performance

4775 words - 20 pages 8 May 2013 To: Origin Energy Limited – Board of Directors From: AFF5250-Group 27 There is the report that you requested to evaluate Origin Energy’s capital structure and cash management performance over past five years, and also forecast future cash flow. The main purpose of this report is to explore company current financial performance and make recommendations regarding to improvements for company for the next strategic planning horizon