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F. WHAT DOES CAPITAL STRUCTURE THEORY ATTEMPT TO DO? WHAT LESSONS CAN BE LEARNED FROM CAPITAL STRUCTURE THEORY?
ANSWER CAPITAL STRUCTURE THEORY PROVIDES SOME INSIGHTS INTO THE VALUE OF DEBT VERSUS EQUITY FINANCING. AN UNDERSTANDING OF CAPITAL STRUCTURE THEORY WILL AID A MANAGER IN FINDING HIS OR HER FIRM¡¦S OPTIMAL CAPITAL STRUCTURE.
MODERN CAPITAL STRUCTURE THEORY BEGAN IN 158, WHEN MODIGLIANI AND MILLER PROVED, UNDER A VERY RESTRICTIVE SET OF ASSUMPTIONS, INCLUDING THE ASSUMPTION OF NO TAXES, THAT A FIRM¡¦S VALUE IS UNAFFECTED BY ITS CAPITAL STRUCTURE. MM¡¦S RESULTS SUGGEST THAT IT DOESN¡¦T MATTER HOW A FIRM FINANCES ITS OPERATIONS BECAUSE CAPITAL STRUCTURE IS IRRELEVANT. DESPITE ITS UNREALISTIC ASSUMPTIONS, MM¡¦S IRRELEVANCE RESULT IS EXTREMELY IMPORTANT. BY INDICATING THE CONDITIONS UNDER WHICH CAPITAL STRUCTURE IS IRRELEVANT, MM ALSO PROVIDED US WITH SOME CLUES ABOUT WHAT IS REQUIRED FOR CAPITAL STRUCTURE TO BE RELEVANT, AND HENCE, TO AFFECT A FIRM¡¦S VALUE.
MM LATER CONSIDERED THE IMPACT OF CORPORATE TAXES. BECAUSE INTEREST PAYMENTS ARE DEDUCTIBLE FOR TAX PURPOSES, THE TOTAL CASH FLOWS TO ALL INVESTORS ARE GREATER FOR A LEVERAGED FIRM THAN AN UNLEVERAGED FIRM. EACH DOLLAR OF DEBT, D, INCREASES THE VALUE OF THE FIRM BY TcD., WHERE Tc IS THE CORPORATE TAX RATE. TcD. IS CALLED THE ¡§TAX SHIELD¡¨ OF DEBT. MM¡¦S MODEL IMPLIES THAT FIRMS SHOULD HAVE 100% DEBT FINANCING.
WHEN BANKRUPTCIES ARE CONSIDERED, THERE IS A TRADE-OFF BETWEEN THE TAX SHIELD ON DEBT AND THE LIKELIHOOD OF FINANCIAL DISTRESS. AT LOW LEVELS OF DEBT, THE TAX SHIELD ON DEBT IS GREATER THAN THE EXPECTED COSTS OF FINANCIAL DISTRESS. AT HIGH LEVELS OF DEBT, EXPECTED BANKRUPTCY COSTS EXCEED THE TAX SHIELD. THIS IMPLIES THAT THERE IS AN OPTIMAL LEVEL OF DEBT.
SIGNALING THEORY RECOGNIZES THAT MANAGERS HAVE BETTER INFORMATION THAN INVESTORS. THIS IMPLIES THAT MANAGERS WOULD SELL STOCK WHEN THE PRICE OF THE STOCK IS GREATER THAN ITS TRUE VALUE. INVESTORS KNOW THIS, AND SO STOCK PRICE SHOULD FALL WHEN COMPANIES ISSUE DEBT.
AGENCY COSTS ARE PRESENT WHEN MANAGERS WASTE FREE CASH FLOW ON PERQUISITES OR NEGATIVE NPV PROJECTS. HIGH LEVELS OF DEBT ¡§BOND¡¨ THE FREE CASH FLOW, SINCE MUCH OF THE FREE CASH FLOW MUST BE COMMITTED TO SERVICING THE DEBT. THIS PREVENTS MANAGERS FROM WASTING FREE CASH FLOW, AND SO HIGH LEVELS OF DEBT SHOULD REDUCE AGENCY COSTS.
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