After completing this chapter, you will be able to do the following:
- Explain the Modigliani–Miller propositions concerning capital structure, including the impact of leverage, taxes, financial distress, agency costs, and asymmetric information on a company’s cost of equity, cost of capital, and optimal capital structure.
- Explain the target capital structure and why actual capital structure may fluctuate around the target.
- Describe the role of debt ratings in capital structure policy.
- Explain factors an analyst should consider in evaluating the impact of capital structure policy on valuation.
- Describe international differences in financial leverage and their implications for investment analysis.
- The goal of the capital structure decision is to determine the financial leverage that maximizes the value of the company (or minimizes the weighted average cost of capital).
- 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, ...