Finance: Capital Markets, Financial Management, and Investment Management

CHAPTER 11

The Corporate Financing Decision

A business invests in new plant and equipment to generate additional revenues and income—the basis for its growth. One way to pay for investments is to generate capital from the company’s operations. Earnings generated by the company belong to the owners and can either be paid to them—in the form of cash dividends—or plowed back into the company.

The owners’ investment in the company is referred to as owners’ equity or, simply, equity. If earnings are plowed back into the company, the owners expect it to be invested in projects that will enhance the value of the company and, hence, enhance the value of their equity. But earnings may not be sufficient to support all profitable investment opportunities. In that case management is faced with a decision: Forego profitable investment opportunities or raise additional capital. New capital can be raised by either borrowing or selling additional ownership interests or both.

The decision about how the company should be financed, whether with debt or equity, is referred to as the capital structure decision. In this chapter, we discuss the capital structure decision. There are different theories about how the firm should be financed and we review these theories in this chapter. In the appendix to this chapter, we present a theory about the capital structure proposed by Franco Modigliani and Merton Miller.

DEBT VS. EQUITY

The capital structure of a company is some mix of the three sources of ...