Financial Economics

23

FINANCING DECISIONS IN PRACTICE

In Chapters 4 and 22, we considered such major factors affecting capital structure as taxes, bankruptcy costs, and agency effects. This chapter considers further practical aspects of choosing financial arrangements, including (1) estimating the costs of different financing sources; (2) timing securities issues when management will not be able to maintain an optimal capital structure at all times; (3) how the views of creditors and investors might affect the timing and amount of securities issued; (4) the significance of insolvency costs for capital structure choices; (5) considerations in developing a dividend policy; and (6) considerations in repurchasing equity and issuing equity via a preemptive rights offering.

23.1 ESTIMATING THE COSTS OF DIFFERENT FUNDING SOURCES

The theory of capital structure provides a framework for analyzing how management can estimate the costs of raising funds from different sources (i.e., new equity or debt). The theory predicts that if additional equity is issued by a firm with both debt and equity in its capital structure, the debt-equity ratio will necessarily fall, and the discount rate applied to all the outstanding equity will usually also fall. On the other hand, an increase in the debt-equity ratio due to the issue of additional riskless debt (assuming it is actually possible to issue more riskless debt) will increase the discount rate applied to the equity but will not affect the rate applied to the debt. ...