Financial Structure and International Debt
Chapter 14
Financial Structure and International Debt
( Questions
1. Objective. What, in simple wording, is the objective sought by finding an optimal capital structure? When taxes and bankruptcy costs are considered, a firm has an optimal financial structure determined by that particular mix of debt and equity that minimizes the firm’s cost of capital for a given level of business risk. If the business risk of new projects differs from the risk of existing projects, the optimal mix of debt and equity would change to recognize trade-offs between business and financial risks.
2. Varying Debt Proportions. As debt in a firm’s capital structure is increased from no debt to a significant proportion of debt (say, 60%), what tends to happen to the cost of debt, to the cost of equity, and to the overall weighted average cost of capital? As the debt ratio, defined as total debt divided by total assets at market values, increases, the overall cost of capital (Kwacc) decreases because of the heavier weight of low-cost debt [Kd(1 − t)] compared to high-cost equity (Ke). The low cost of debt is, of course, due to the tax deductibility of interest shown by the term (1 − t). Partly offsetting the favorable effect of more debt is an increase in the cost of equity (Ke), because investors perceive greater financial risk. Nevertheless, the overall weighted average after-tax cost of capital (Kwacc) continues to decline as the debt ratio increases, until financial risk becomes so serious that investors and management alike perceive a real danger of insolvency. This result causes a sharp increase in the cost of new debt and equity, thus increasing the weighted average cost of capital. The low point on the resulting U-shaped cost of capital curve defines the debt ratio range in which the cost of capital is minimized. Most theorists believe that the low point is actually a rather broad, flat area encompassing a wide range of debt ratios, 30% to 60%.
Financial Structure and International Debt
( Questions
1. Objective. What, in simple wording, is the objective sought by finding an optimal capital structure? When taxes and bankruptcy costs are considered, a firm has an optimal financial structure determined by that particular mix of debt and equity that minimizes the firm’s cost of capital for a given level of business risk. If the business risk of new projects differs from the risk of existing projects, the optimal mix of debt and equity would change to recognize trade-offs between business and financial risks.
2. Varying Debt Proportions. As debt in a firm’s capital structure is increased from no debt to a significant proportion of debt (say, 60%), what tends to happen to the cost of debt, to the cost of equity, and to the overall weighted average cost of capital? As the debt ratio, defined as total debt divided by total assets at market values, increases, the overall cost of capital (Kwacc) decreases because of the heavier weight of low-cost debt [Kd(1 − t)] compared to high-cost equity (Ke). The low cost of debt is, of course, due to the tax deductibility of interest shown by the term (1 − t). Partly offsetting the favorable effect of more debt is an increase in the cost of equity (Ke), because investors perceive greater financial risk. Nevertheless, the overall weighted average after-tax cost of capital (Kwacc) continues to decline as the debt ratio increases, until financial risk becomes so serious that investors and management alike perceive a real danger of insolvency. This result causes a sharp increase in the cost of new debt and equity, thus increasing the weighted average cost of capital. The low point on the resulting U-shaped cost of capital curve defines the debt ratio range in which the cost of capital is minimized. Most theorists believe that the low point is actually a rather broad, flat area encompassing a wide range of debt ratios, 30% to 60%.