Corporate Finance: A Practical Approach, Second Edition

CHAPTER 5

CAPITAL STRUCTURE

Raj Aggarwal, CFA

Akron, Ohio, U.S.A.

Pamela Peterson Drake, CFA

Harrisonburg Virginia, U.S.A.

Adam Kobor, CFA

Washington, DC, U.S.A.

Gregory Noronha, CFA

Tacoma Washington U.S.A.

LEARNING OUTCOMES

After completing this chapter, you will be able to do the following:

• Explain the Modigliani–Miller propositions concerning capital structure, including the impact of leverage, taxes, financial distress, agency costs, and asymmetric information on a company’s cost of equity, cost of capital, and optimal capital structure.
• Explain the target capital structure and why actual capital structure may fluctuate around the target.
• Describe the role of debt ratings in capital structure policy.
• Explain factors an analyst should consider in evaluating the impact of capital structure policy on valuation.
• Describe international differences in financial leverage and their implications for investment analysis.

1. INTRODUCTION

The most important decision a company makes in its pursuit of maximizing its value is typically the decision concerning what products to manufacture and/or what services to offer. The decision on how to finance investments (e.g., in factories and equipment), the so-called capital structure decision, is often seen as less important, even secondary. As we will see in this chapter, the importance of the capital structure decision depends on the assumptions one makes about capital markets and the agents operating in it.

Under the most restrictive set ...