Notes of Capital Structure
Supplementary Notes: Capital Structure by Kyung Hwan Shim University of New South Wales Australian School of Business School of Banking & Finance for FINS 1613 S1 2011 May 14, 2011 ∗
These notes are preliminary and under development. They are made available for FINS 1613 S1 2011 students only and may not be distributed or used without the author’s written consent.
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1
Contents
1 Introduction 2 Financial Leverage 3 M&M Proposition I: Capital Structure Irrelevance 4 M&M Proposition II: Capital Structure Irrelevance 4.1 4.2 M&M Proposition II With Riskless Debt . . . . . . . . . . . . . . . . . . . . . . . . M&M Proposition II with Riskless Debt: Betas . . . . . . . . . . . . . . . . . . . . 3 4 5 8 8 11 12 17 17 18 19 22 22 23 23 23 23 24
5 M&M I & II with Taxes: Riskless Debt and Tax Shields 6 M&M with Taxes & Cost of Financial Distress 6.1 6.2 6.3 Bankruptcy Costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Costs of Financial Distress . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Static Trade Off Theory: Tax Shield Gains vs. Bankruptcy & Distress Costs . . .
7 Optimal Capital Structure Policy: Empirical Evidence 7.1 7.2 Asset Type and Debt ratios: the Static Trade Off Explanation . . . . . . . . . . . High Profit & Low Debt Ratio Firms: The Pecking Order Theory Explanation . .
8 Final Words on Capital Structure 8.1 8.2 Debt and Corporate Discipline . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other Things to Consider . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
9 Conclusions
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1
Introduction
A firm’s mix of debt and equity is what is called the firm’s capital structure. The capital structure of a company determines how its operating cash flows will be split between equityholders and debtholders. The cash flows of an all equity financed company belongs to the equity holders, while a company that has both debt and equity will have its cash flows split
These notes are preliminary and under development. They are made available for FINS 1613 S1 2011 students only and may not be distributed or used without the author’s written consent.
∗
1
Contents
1 Introduction 2 Financial Leverage 3 M&M Proposition I: Capital Structure Irrelevance 4 M&M Proposition II: Capital Structure Irrelevance 4.1 4.2 M&M Proposition II With Riskless Debt . . . . . . . . . . . . . . . . . . . . . . . . M&M Proposition II with Riskless Debt: Betas . . . . . . . . . . . . . . . . . . . . 3 4 5 8 8 11 12 17 17 18 19 22 22 23 23 23 23 24
5 M&M I & II with Taxes: Riskless Debt and Tax Shields 6 M&M with Taxes & Cost of Financial Distress 6.1 6.2 6.3 Bankruptcy Costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Costs of Financial Distress . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Static Trade Off Theory: Tax Shield Gains vs. Bankruptcy & Distress Costs . . .
7 Optimal Capital Structure Policy: Empirical Evidence 7.1 7.2 Asset Type and Debt ratios: the Static Trade Off Explanation . . . . . . . . . . . High Profit & Low Debt Ratio Firms: The Pecking Order Theory Explanation . .
8 Final Words on Capital Structure 8.1 8.2 Debt and Corporate Discipline . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other Things to Consider . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
9 Conclusions
2
1
Introduction
A firm’s mix of debt and equity is what is called the firm’s capital structure. The capital structure of a company determines how its operating cash flows will be split between equityholders and debtholders. The cash flows of an all equity financed company belongs to the equity holders, while a company that has both debt and equity will have its cash flows split