2.23 Capital Structure

describe target capital structure and explain why a company's actual capital structure may fluctuate around its target;

A company may identify its target capital structure, but its capital structure at any point in time may not be equal to its target for many reasons, including that management may exploit tactical opportunities in financing sources, market-value fluctuations in its securities, or just be unable to maintain the capital structure due to market conditions.

explain factors an analyst should consider in evaluating the effect of capital structure policy on valuation;

In evaluating a company's capital structure, the financial analyst must look at the capital structure of the company over time, the capital structure of competitors that have similar business risk, and company-specific factors, such as the quality of corporate governance, that may affect agency costs, among other factors. Good corporate governance and accounting transparency should lower the net agency costs of equity.

explain the Modigliani-Miller propositions regarding capital structure, including the effects of leverage, taxes, financial distress, agency costs, and asymmetric information on a company's cost of equity, cost of capital, and optimal capital structure;

In the Modigliani and Miller theory developed without taxes, capital structure is irrelevant and has no effect on company value. The deductibility of interest lowers the cost of debt and the cost of capital for the company as a whole. Adding the tax shield provided by debt to the Modigliani and Miller framework suggests that the optimal capital structure is all debt. In the Modigliani and Miller propositions with and without taxes, increasing a company's relative use of debt in the capital structure increases the risk for equity providers and, hence, the cost of equity capital. When there are bankruptcy costs, a high debt ratio increases the risk of bankruptcy. Using more debt in a company's capital structure reduces the net agency costs of equity. The costs of asymmetric information increase as more equity is used versus debt, suggesting the pecking order theory of leverage, in which new equity issuance is the least preferred method of raising capital. According to the static trade-off theory of capital structure, in choosing a capital structure, a company balances the value of the tax benefit from deductibility of interest with the present value of the costs of financial distress. At the optimal target capital structure, the incremental tax shield benefit is exactly offset by the incremental costs of financial distress.

describe the role of debt ratings in capital structure policy;

Many companies have goals for maintaining a certain credit rating, and these goals are influenced by the relative costs of debt financing among the different rating classes.

describe international differences in the use of financial leverage, factors that explain these differences, and implications of these differences for investment analysis.

When comparing capital structures of companies in different countries, an analyst must consider a variety of characteristics that might differ and affect both the typical capital structure and the debt maturity structure. The major characteristics fall into three categories: institutional and legal environment, financial markets and banking sector, and macroeconomic environment.

Tax effect on cost of capital

r0 as the cost of capital for a company financed only by equity rd = the before-tax marginal cost of debt capital, and is equal to the after-tax marginal cost of debt because there are no taxes by assumption re = the marginal cost of equity capital D = the market value of debt E = the market value of equity V = the value of the company, which is equal to D + E