Description
Debt Policy of the Company
Does Debt Policy Matter ?
Topics Covered
? Leverage in a Tax Free Environment
? How Leverage Affects Returns
? The Traditional Position
Overview
? The explanation of MM’s Propositions I and II.
? Proposition I is proved using a simplified version of
MM’s “arbitrage” proof.
? MM’s Proposition II is derived using Proposition I.
? Lastly, the traditional position
?Uncertainty about future operating income (EBIT).
?Note that business risk focuses on operating income,
so it ignores financing effects.
What is business risk?
Probability
EBIT E(EBIT) 0
Low risk
High risk
Factors That Influence Business Risk
? Uncertainty about demand (unit sales).
? Uncertainty about output prices.
? Uncertainty about input costs.
? Product and other types of liability.
? Degree of operating leverage (DOL).
What is operating leverage, and how does
it affect a firm’s business risk?
Question
? Operating leverage is the use of fixed costs rather
than variable costs.
? The higher the proportion of fixed costs within a
firm’s overall cost structure, the greater the
operating leverage.
? Higher operating leverage leads to more business
risk, because a small sales decline causes a
larger profit decline.
Sales
$
Rev.
TC
FC
Q
BE
Sales
$
Rev.
TC
FC
Q
BE
Profit
}
Probability
EBIT
L
Low operating leverage
High operating leverage
EBIT
H
?In the typical situation, higher operating
leverage leads to higher expected EBIT, but
also increases risk.
Business Risk versus Financial Risk
? Business risk:
? Uncertainty in future EBIT.
? Depends on business factors such as competition,
operating leverage, etc.
? Financial risk:
? Additional business risk concentrated on common
stockholders when financial leverage is used.
? Depends on the amount of debt and preferred stock
financing.
From a shareholder’s perspective,
how are financial and business
risk measured in the stand-alone
sense?
Question
Stand-alone Business Financial
risk risk risk
= + .
Stand-alone risk = o
ROE
.
Business risk = o
ROE(U)
.
Financial risk = o
ROE
- o
ROE(U)
.
M&M (Debt Policy Doesn’t Matter)
? Modigliani & Miller Proposition I
? When there are no taxes and capital markets
function well, it makes no difference whether the
firm borrows or individual shareholders borrow.
Therefore, the market value of a company does not
depend on its capital structure.
MM Theory: Zero Taxes
? MM prove, under a very restrictive set of
assumptions, that a firm’s value is unaffected by
its financing mix.
? Therefore, capital structure is irrelevant.
? Any increase in ROE resulting from financial
leverage is exactly offset by the increase in risk.
Basic Proposition
? The overall cost of capital and the value of the
firm are independent of the of its capital
structure.
? The total value is given by capitalizing the
expected stream of operating earnings at a
discount rate appropriate for its risk class.
? Cost of equity is equal to the capitalization rate
of the pure equity stream plus a premium for
financial risk.
M&M (Debt Policy Doesn’t Matter)
Assumptions
? By issuing 1 security rather than 2, company
diminishes investor choice. This does not reduce
value if:
? Investors do not need choice, OR
? There are sufficient alternative securities
? Capital structure does not affect cash flows e.g...
? No taxes
? No bankruptcy costs
? No effect on management incentives
The effect of leverage in a
competitive tax-free economy
? The choice of capital structure is a marketing problem; that
is, the problem is to find the combination of securities that
has the greatest overall appeal to investors and therefore
maximizes the market value of the firm.
? MM’s Proposition I states that all combinations of debt and
equity are equally good.
? Proposition I can be generalized as the law of
conservation of value: The value of the pie is
independent of how it is sliced.
? The values of the parts will always sum up to the value of
the unsliced pie.
? MM I: Value of the firm is determined by real assets.
Example - Macbeth Spot Removers - All Equity Financed
20 15 10 % 5 (%) shares on Return
2.00 1.50 1.00 $.50 share per Earnings
2,000 1,500 1,000 $500 Income Operating
D C B A
Outcomes
10,000 $ Shares of Value Market
$10 share per Price
1,000 shares of Number
Data
M&M (Debt Policy Doesn’t Matter)
Expected
outcome
For an all-equity firm, return on
equity is equal to return on
assets. There are no taxes. The
returns to the stockholders are
shown under different
assumptions about operating
income.
Example
cont.
50%
debt
30 20 10 0% (%) shares on Return
3 2 1 $0 share per Earnings
500 , 1 1,000 500 $0 earnings Equity
500 500 500 $500 Interest
000 , 2 1,500 1,000 $500 Income Operating
C B A
Outcomes
5,000 $ debt of ue Market val
5,000 $ Shares of Value Market
$10 share per Price
500 shares of Number
Data
D
M&M (Debt Policy Doesn’t Matter)
Expected return
on equity is higher.
This shows the
return to
shareholders
under different
assumptions about
operating income.
Example - Macbeth’s - All Equity Financed
- Debt replicated by investors
30 20 10 0% (%) investment $10 on Return
3.00 2.00 1.00 0 $ investment on earnings Net
1.00 1.00 1.00 $1.00 10% @ Interest : LESS
4.00 3.00 2.00 $1.00 shares two on Earnings
D C B A
Outcomes
M&M (Debt Policy Doesn’t Matter)
Shareholders under all-equity-financed firm can replicate the firm’s leverage by borrowing on their
account. Here the investor is borrowing $10 and buying the second share. The investor can
replicate the outcome of the levered firm. The firms should have the same value.
MM'S PROPOSITION I
If capital markets are doing their job,
firms cannot increase value by tinkering
with capital structure.
V is independent of the debt ratio.
No Magic in Financial Leverage
Proposition I and Macbeth
20 15 (%) share per return Expected
10 10 ($) share per Price
2.00 1.50 ($) share per earnings Expected
Equity and Debt Equal
: Structure Proposed
Equity All
: Structure Cuttent
Macbeth continued
The price per share remains the same, but the expected return per share increases
with leverage.
How leverage affects returns
? MM’s Proposition II relates the equity capitalization
rate to leverage.
? Leverage affects the equity beta.
? The effect of capital structure on the return on equity
and changing financial risk for the shareholders.
Leverage and Returns
securities all of ue market val
income operating expected
r assets on return Expected
a
= =
|
.
|
\
|
×
+
+
|
.
|
\
|
×
+
=
E D A
r
E D
E
r
E D
D
r
The expected return on assets can be written in the above form - as
the expected return on the portfolio is equal to the weighed
average of the expected returns on the individual holdings.
M&M Proposition II
15 .
000 , 10
1500
securities all of ue market val
income operating expected
r r
A E
= =
= =
( )
D A A E
r r
V
D
r r ÷ + =
Macbeth continued
rA = [D/(D+E)](rD) + [E/( D+E)](rE);
rA(D+E) = (D)(rD) + E(rE); rE = rA(D/E + 1) – rD(D/E);
rE = rA + [D/E](rA – rD);
For an all-equity firm
rA = rE = 0.15
M&M Proposition II
15 .
000 , 10
1500
securities all of ue market val
income operating expected
r r
A E
= =
= =
( )
D A A E
r r
V
D
r r ÷ + =
( )
20% or 20 .
10 . 15 .
5000
5000
15 .
=
÷ + =
E
r
Macbeth continued
Return on equity increases linearly with leverage (debt-equity ratio). This is MM’s
Proposition II.
r
D
E
r
D
r
E
M&M Proposition II graphically
r
A
Risk free debt Risky debt
Leverage and Risk
20 0 shares on Return
2 0 ($) share per Earnings : debt % 50
15 5 shares on Return
1.50 .50 ($) share per Earnings equity All
$1,500
Income
$500
Operating
Macbeth continued
Leverage increases the risk of Macbeth shares
This is in accordance with MM’s Proposition II.
Leverage and Returns
|
.
|
\
|
×
+
+
|
.
|
\
|
×
+
=
E D A
B
E D
E
B
A D
D
B
( )
D A A E
B B
V
D
B B ÷ + =
A similar relationship can be obtained for equity betas.
The traditional position
? Weighed average cost of capital is a U-shaped function of leverage -
only possible in imperfect capital markets.
? Market imperfections - high transaction costs might create a clientele
for leveraged shares. But they will not pay a premium for levered
shares if the present supply of levered shares meets their needs.
? The financing objective is best expressed as “find the package of
securities that maximizes firm value,” not “find the package of securities
that minimizes the weighted average cost of capital.”
? Capital markets do evolve; new securities are invented and become
popular. This shows that Proposition I is not always strictly and
universally true. If it were, there would be no demand for new types of
securities.
? Yet, it is difficult to think of new security types that corporations could
issue and thereby tap a clientele of constrained investors.
WACC
|
.
|
\
|
× +
|
.
|
\
|
× = =
E D A
r
V
E
r
V
D
r WACC
? WACC is the traditional view of capital
structure, risk and return.
The weighted average cost of capital is the weighted
average of debt and equity returns.
WACC
.10=r
D
.20=r
E
.15=r
A
B
E
B
A
B
D
Risk
Expected
Return
Equity
All
assets
Debt
This graph shows the relationship between beta and the expected return on the security.
WACC
Example - A firm has $2 mil of debt and 100,000 of
outstanding shares at $30 each. If they can borrow
at 8% and the stockholders require 15% return what
is the firm’s WACC?
D = $2 million
E = 100,000 shares X $30 per share = $3 million
V = D + E = 2 + 3 = $5 million
WACC
Example - A firm has $2 mil of debt and 100,000 of
outstanding shares at $30 each. If they can borrow at
8% and the stockholders require 15% return what is the
firm’s WACC?
D = $2 million
E = 100,000 shares X $30 per share = $3 million
V = D + E = 2 + 3 = $5 million
12.2% or 122 .
15 .
5
3
08 .
5
2
=
|
.
|
\
|
× +
|
.
|
\
|
× =
|
.
|
\
|
× +
|
.
|
\
|
× =
E D
r
V
E
r
V
D
WACC
r
D
V
r
D
r
E
r
E
=WACC
WACC
According to the traditional views the expected rate of return on
equity is unaffected by financial leverage. Then WACC declines as the
firm borrows more. This can only happen in an imperfect market.
r
D
V
r
D
r
E
WACC
WACC (traditional view)
The traditionalists say that borrowing at first increases rE more slowly
than MM predicts, but rE shoots up with higher levels of debt. Using the
right amount of debt can minimize the weighted average cost of capital.
r
D
V
r
D
r
E
WACC
WACC (M&M view)
This is MM’s position and should hold good under perfect market
conditions.
Hamada’s Equation
? MM theory implies that beta changes with leverage.
? b
U
is the beta of a firm when it has no debt (the
unlevered beta)
? b
L
= b
U
(1 + (1 - T)(D/E))
? In practice, D/E is measured in book values when b
L
is calculated.
Trade-off Theory
? MM theory ignores bankruptcy (financial distress)
costs, which increase as more leverage is used.
? At low leverage levels, tax benefits outweigh
bankruptcy costs.
? At high levels, bankruptcy costs outweigh tax benefits.
? An optimal capital structure exists that balances these
costs and benefits.
Signaling Theory
? MM assumed that investors and managers have the
same information.
? But, managers often have better information. Thus,
they would:
? Sell stock if stock is overvalued.
? Sell bonds if stock is undervalued.
? Investors understand this, so view new stock sales as
a negative signal.
? Implications for managers?
Debt Financing As a Managerial
Constraint
? One agency problem is that managers can use
corporate funds for non-value maximizing purposes.
? The use of financial leverage:
? Forces discipline on managers.
? However, it also increases risk of financial distress.
The Optimal Capital Structure
? Calculate the cost of equity at each level of
debt.
? Calculate the value of equity at each level of
debt.
? Calculate the total value of the firm (value of
equity + value of debt) at each level of debt.
? The optimal capital structure maximizes the
total value of the firm.
? Debt ratios of other firms in the industry.
? Pro forma coverage ratios at different capital
structures under different economic scenarios.
? Lender and rating agency attitudes
(impact on bond ratings).
? Reserve borrowing capacity.
? Effects on control.
? Type of assets: Are they tangible, and hence
suitable as collateral?
? Tax rates.
How would higher or lower
business risk affect the optimal
capital structure?
Question
? At any debt level, the firm’s probability of financial
distress would be higher. Both k
d
and k
s
would rise
faster than before. The end result would be an
optimal capital structure with less debt.
? Lower business risk would have the opposite effect.
What type of analysis should firms
conduct to help find their optimal, or
target, capital structure?
Question
? Financial forecasting models can help show how
capital structure changes are likely to affect stock
prices, coverage ratios, and so on.
? Forecasting models can generate results under
various scenarios, but the financial manager must
specify appropriate input values, interpret the
output, and eventually decide on a target capital
structure.
? In the end, capital structure decision will be based
on a combination of analysis and judgment.
What other factors would managers
consider when setting the target
capital structure?
Question
doc_570597405.pptx
Debt Policy of the Company
Does Debt Policy Matter ?
Topics Covered
? Leverage in a Tax Free Environment
? How Leverage Affects Returns
? The Traditional Position
Overview
? The explanation of MM’s Propositions I and II.
? Proposition I is proved using a simplified version of
MM’s “arbitrage” proof.
? MM’s Proposition II is derived using Proposition I.
? Lastly, the traditional position
?Uncertainty about future operating income (EBIT).
?Note that business risk focuses on operating income,
so it ignores financing effects.
What is business risk?
Probability
EBIT E(EBIT) 0
Low risk
High risk
Factors That Influence Business Risk
? Uncertainty about demand (unit sales).
? Uncertainty about output prices.
? Uncertainty about input costs.
? Product and other types of liability.
? Degree of operating leverage (DOL).
What is operating leverage, and how does
it affect a firm’s business risk?
Question
? Operating leverage is the use of fixed costs rather
than variable costs.
? The higher the proportion of fixed costs within a
firm’s overall cost structure, the greater the
operating leverage.
? Higher operating leverage leads to more business
risk, because a small sales decline causes a
larger profit decline.
Sales
$
Rev.
TC
FC
Q
BE
Sales
$
Rev.
TC
FC
Q
BE
Profit
}
Probability
EBIT
L
Low operating leverage
High operating leverage
EBIT
H
?In the typical situation, higher operating
leverage leads to higher expected EBIT, but
also increases risk.
Business Risk versus Financial Risk
? Business risk:
? Uncertainty in future EBIT.
? Depends on business factors such as competition,
operating leverage, etc.
? Financial risk:
? Additional business risk concentrated on common
stockholders when financial leverage is used.
? Depends on the amount of debt and preferred stock
financing.
From a shareholder’s perspective,
how are financial and business
risk measured in the stand-alone
sense?
Question
Stand-alone Business Financial
risk risk risk
= + .
Stand-alone risk = o
ROE
.
Business risk = o
ROE(U)
.
Financial risk = o
ROE
- o
ROE(U)
.
M&M (Debt Policy Doesn’t Matter)
? Modigliani & Miller Proposition I
? When there are no taxes and capital markets
function well, it makes no difference whether the
firm borrows or individual shareholders borrow.
Therefore, the market value of a company does not
depend on its capital structure.
MM Theory: Zero Taxes
? MM prove, under a very restrictive set of
assumptions, that a firm’s value is unaffected by
its financing mix.
? Therefore, capital structure is irrelevant.
? Any increase in ROE resulting from financial
leverage is exactly offset by the increase in risk.
Basic Proposition
? The overall cost of capital and the value of the
firm are independent of the of its capital
structure.
? The total value is given by capitalizing the
expected stream of operating earnings at a
discount rate appropriate for its risk class.
? Cost of equity is equal to the capitalization rate
of the pure equity stream plus a premium for
financial risk.
M&M (Debt Policy Doesn’t Matter)
Assumptions
? By issuing 1 security rather than 2, company
diminishes investor choice. This does not reduce
value if:
? Investors do not need choice, OR
? There are sufficient alternative securities
? Capital structure does not affect cash flows e.g...
? No taxes
? No bankruptcy costs
? No effect on management incentives
The effect of leverage in a
competitive tax-free economy
? The choice of capital structure is a marketing problem; that
is, the problem is to find the combination of securities that
has the greatest overall appeal to investors and therefore
maximizes the market value of the firm.
? MM’s Proposition I states that all combinations of debt and
equity are equally good.
? Proposition I can be generalized as the law of
conservation of value: The value of the pie is
independent of how it is sliced.
? The values of the parts will always sum up to the value of
the unsliced pie.
? MM I: Value of the firm is determined by real assets.
Example - Macbeth Spot Removers - All Equity Financed
20 15 10 % 5 (%) shares on Return
2.00 1.50 1.00 $.50 share per Earnings
2,000 1,500 1,000 $500 Income Operating
D C B A
Outcomes
10,000 $ Shares of Value Market
$10 share per Price
1,000 shares of Number
Data
M&M (Debt Policy Doesn’t Matter)
Expected
outcome
For an all-equity firm, return on
equity is equal to return on
assets. There are no taxes. The
returns to the stockholders are
shown under different
assumptions about operating
income.
Example
cont.
50%
debt
30 20 10 0% (%) shares on Return
3 2 1 $0 share per Earnings
500 , 1 1,000 500 $0 earnings Equity
500 500 500 $500 Interest
000 , 2 1,500 1,000 $500 Income Operating
C B A
Outcomes
5,000 $ debt of ue Market val
5,000 $ Shares of Value Market
$10 share per Price
500 shares of Number
Data
D
M&M (Debt Policy Doesn’t Matter)
Expected return
on equity is higher.
This shows the
return to
shareholders
under different
assumptions about
operating income.
Example - Macbeth’s - All Equity Financed
- Debt replicated by investors
30 20 10 0% (%) investment $10 on Return
3.00 2.00 1.00 0 $ investment on earnings Net
1.00 1.00 1.00 $1.00 10% @ Interest : LESS
4.00 3.00 2.00 $1.00 shares two on Earnings
D C B A
Outcomes
M&M (Debt Policy Doesn’t Matter)
Shareholders under all-equity-financed firm can replicate the firm’s leverage by borrowing on their
account. Here the investor is borrowing $10 and buying the second share. The investor can
replicate the outcome of the levered firm. The firms should have the same value.
MM'S PROPOSITION I
If capital markets are doing their job,
firms cannot increase value by tinkering
with capital structure.
V is independent of the debt ratio.
No Magic in Financial Leverage
Proposition I and Macbeth
20 15 (%) share per return Expected
10 10 ($) share per Price
2.00 1.50 ($) share per earnings Expected
Equity and Debt Equal
: Structure Proposed
Equity All
: Structure Cuttent
Macbeth continued
The price per share remains the same, but the expected return per share increases
with leverage.
How leverage affects returns
? MM’s Proposition II relates the equity capitalization
rate to leverage.
? Leverage affects the equity beta.
? The effect of capital structure on the return on equity
and changing financial risk for the shareholders.
Leverage and Returns
securities all of ue market val
income operating expected
r assets on return Expected
a
= =
|
.
|
\
|
×
+
+
|
.
|
\
|
×
+
=
E D A
r
E D
E
r
E D
D
r
The expected return on assets can be written in the above form - as
the expected return on the portfolio is equal to the weighed
average of the expected returns on the individual holdings.
M&M Proposition II
15 .
000 , 10
1500
securities all of ue market val
income operating expected
r r
A E
= =
= =
( )
D A A E
r r
V
D
r r ÷ + =
Macbeth continued
rA = [D/(D+E)](rD) + [E/( D+E)](rE);
rA(D+E) = (D)(rD) + E(rE); rE = rA(D/E + 1) – rD(D/E);
rE = rA + [D/E](rA – rD);
For an all-equity firm
rA = rE = 0.15
M&M Proposition II
15 .
000 , 10
1500
securities all of ue market val
income operating expected
r r
A E
= =
= =
( )
D A A E
r r
V
D
r r ÷ + =
( )
20% or 20 .
10 . 15 .
5000
5000
15 .
=
÷ + =
E
r
Macbeth continued
Return on equity increases linearly with leverage (debt-equity ratio). This is MM’s
Proposition II.
r
D
E
r
D
r
E
M&M Proposition II graphically
r
A
Risk free debt Risky debt
Leverage and Risk
20 0 shares on Return
2 0 ($) share per Earnings : debt % 50
15 5 shares on Return
1.50 .50 ($) share per Earnings equity All
$1,500
Income
$500
Operating
Macbeth continued
Leverage increases the risk of Macbeth shares
This is in accordance with MM’s Proposition II.
Leverage and Returns
|
.
|
\
|
×
+
+
|
.
|
\
|
×
+
=
E D A
B
E D
E
B
A D
D
B
( )
D A A E
B B
V
D
B B ÷ + =
A similar relationship can be obtained for equity betas.
The traditional position
? Weighed average cost of capital is a U-shaped function of leverage -
only possible in imperfect capital markets.
? Market imperfections - high transaction costs might create a clientele
for leveraged shares. But they will not pay a premium for levered
shares if the present supply of levered shares meets their needs.
? The financing objective is best expressed as “find the package of
securities that maximizes firm value,” not “find the package of securities
that minimizes the weighted average cost of capital.”
? Capital markets do evolve; new securities are invented and become
popular. This shows that Proposition I is not always strictly and
universally true. If it were, there would be no demand for new types of
securities.
? Yet, it is difficult to think of new security types that corporations could
issue and thereby tap a clientele of constrained investors.
WACC
|
.
|
\
|
× +
|
.
|
\
|
× = =
E D A
r
V
E
r
V
D
r WACC
? WACC is the traditional view of capital
structure, risk and return.
The weighted average cost of capital is the weighted
average of debt and equity returns.
WACC
.10=r
D
.20=r
E
.15=r
A
B
E
B
A
B
D
Risk
Expected
Return
Equity
All
assets
Debt
This graph shows the relationship between beta and the expected return on the security.
WACC
Example - A firm has $2 mil of debt and 100,000 of
outstanding shares at $30 each. If they can borrow
at 8% and the stockholders require 15% return what
is the firm’s WACC?
D = $2 million
E = 100,000 shares X $30 per share = $3 million
V = D + E = 2 + 3 = $5 million
WACC
Example - A firm has $2 mil of debt and 100,000 of
outstanding shares at $30 each. If they can borrow at
8% and the stockholders require 15% return what is the
firm’s WACC?
D = $2 million
E = 100,000 shares X $30 per share = $3 million
V = D + E = 2 + 3 = $5 million
12.2% or 122 .
15 .
5
3
08 .
5
2
=
|
.
|
\
|
× +
|
.
|
\
|
× =
|
.
|
\
|
× +
|
.
|
\
|
× =
E D
r
V
E
r
V
D
WACC
r
D
V
r
D
r
E
r
E
=WACC
WACC
According to the traditional views the expected rate of return on
equity is unaffected by financial leverage. Then WACC declines as the
firm borrows more. This can only happen in an imperfect market.
r
D
V
r
D
r
E
WACC
WACC (traditional view)
The traditionalists say that borrowing at first increases rE more slowly
than MM predicts, but rE shoots up with higher levels of debt. Using the
right amount of debt can minimize the weighted average cost of capital.
r
D
V
r
D
r
E
WACC
WACC (M&M view)
This is MM’s position and should hold good under perfect market
conditions.
Hamada’s Equation
? MM theory implies that beta changes with leverage.
? b
U
is the beta of a firm when it has no debt (the
unlevered beta)
? b
L
= b
U
(1 + (1 - T)(D/E))
? In practice, D/E is measured in book values when b
L
is calculated.
Trade-off Theory
? MM theory ignores bankruptcy (financial distress)
costs, which increase as more leverage is used.
? At low leverage levels, tax benefits outweigh
bankruptcy costs.
? At high levels, bankruptcy costs outweigh tax benefits.
? An optimal capital structure exists that balances these
costs and benefits.
Signaling Theory
? MM assumed that investors and managers have the
same information.
? But, managers often have better information. Thus,
they would:
? Sell stock if stock is overvalued.
? Sell bonds if stock is undervalued.
? Investors understand this, so view new stock sales as
a negative signal.
? Implications for managers?
Debt Financing As a Managerial
Constraint
? One agency problem is that managers can use
corporate funds for non-value maximizing purposes.
? The use of financial leverage:
? Forces discipline on managers.
? However, it also increases risk of financial distress.
The Optimal Capital Structure
? Calculate the cost of equity at each level of
debt.
? Calculate the value of equity at each level of
debt.
? Calculate the total value of the firm (value of
equity + value of debt) at each level of debt.
? The optimal capital structure maximizes the
total value of the firm.
? Debt ratios of other firms in the industry.
? Pro forma coverage ratios at different capital
structures under different economic scenarios.
? Lender and rating agency attitudes
(impact on bond ratings).
? Reserve borrowing capacity.
? Effects on control.
? Type of assets: Are they tangible, and hence
suitable as collateral?
? Tax rates.
How would higher or lower
business risk affect the optimal
capital structure?
Question
? At any debt level, the firm’s probability of financial
distress would be higher. Both k
d
and k
s
would rise
faster than before. The end result would be an
optimal capital structure with less debt.
? Lower business risk would have the opposite effect.
What type of analysis should firms
conduct to help find their optimal, or
target, capital structure?
Question
? Financial forecasting models can help show how
capital structure changes are likely to affect stock
prices, coverage ratios, and so on.
? Forecasting models can generate results under
various scenarios, but the financial manager must
specify appropriate input values, interpret the
output, and eventually decide on a target capital
structure.
? In the end, capital structure decision will be based
on a combination of analysis and judgment.
What other factors would managers
consider when setting the target
capital structure?
Question
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