In Chapter 4, we investigated the conditions under which changes in capital structure cannot affect firm value. We showed that in a perfect capital market, although debt is usually less risky than equity, and therefore has a lower cost than equity, it does not follow that using more and apparently lower-cost debt will necessarily lower the firm's weighted average cost of capital. The conclusion in Chapter 4 was that in a perfect capital market without corporate taxation, splitting up the cash flow among the different claim holders of the firm does not affect the firm's value. Put quite simply: The capital structure decision is irrelevant. As a result, in a perfect capital market there is no optimal capital structure.

In this chapter, we will look at conditions under which a firm's value will indeed be affected by its capital structure by relaxing the perfect capital market assumption. We begin by showing how debt offers a tax advantage that can affect the firm's cost of capital. This result would suggest that the capital structure is relevant and suggests that management use the maximum amount of debt. But we then take a look at other factors that management should consider before it pursues a policy of maximum financial leverage. Specifically, we discuss how bankruptcy costs can limit the tax advantage of debt. We make similar arguments regarding agency costs and heterogeneous expectations. The importance of these factors for the theory of dividend ...

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