Chapter 17
Capital Structure Determination
17-1
© Pearson Education Limited 2004 Fundamentals of Financial Management, 12/e
Created by: Gregory A. Kuhlemeyer, Ph.D. Carroll College, Waukesha, WI
17-4
A Conceptual Look -Relevant Rates of Return
ki = the yield on the company’s debt
I
Annual interest on debt
ki = B = Market value of debt
Assumptions: • Interest paid each and every year • Bond life is infinite • Results in the valuation of a perpetual bond • No taxes (Note: allows us to focus on just
stock outstanding
Assumptions: • Earnings are not expected to grow • 100% dividend payout • Results in the valuation of a perpetuity • Appropriate in this case for illustrating the
Explain the traditional approach to capital structure and the valuation of a firm.
Discuss the relationship between financial leverage and the cost of capital as originally set forth by Modigliani and Miller (M&M) and evaluate their arguments.
After studying Chapter 17,
you should be able to:
Define n the net operating income (NOI) approach to capital structure and valuation of a firm; and, calculate a firm's value using this approach.
Assumptions:
• V = B + S = total market value of the firm • O = I + E = net operating income = interest
Concerned with the effect of capital market decisions on security prices.
Assume: (1) investment and asset management decisions are held constant and (2) consider only debt-versus-equity financing.
theory of the firm
17-6
A Conceptual Look -Relevant Rates of Return
ko = an overall capitalization rate for the firm
OO
ko = VV
=
Net operating income Total market value of the firm
Describe various market imperfections and other "real world" factors that tend to dilute M&M’s original position.
Present a number of reasonable arguments for believing that an optimal capital structure exists in theory.
capital structure issues.)
17-5
A Conceptual Look -Relevant Rates of Return
ke = the expected return on the company’s equity
ke =
EE SS
=
Earnings available to common shareholders Market value of common
Explain how financial structure changes can be used for financial signaling purposes, and give some examples.
17-2
Capital Structure Determination
A Conceptual Look The Total-Value Principle Presence of Market Imperfections and Incentive Issues The Effect of Taxes Taxes and Market Imperfections Combined Financial Signaling Timing and Flexibility Financing Checklist
17-3
Capital Structure
Capital Structure -- The mix (or proportion) of a firm’s permanent long-term financing
represented by debt, preferred stock, and common stock equity.