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So Does Capital Structure Policy Matter? So Does Capital Structure Policy Matter?
The M&M proposition suggest that the capital structure does not matter in perfect capital markets with no taxes and no bankruptcy costs. No matter how much the firm borrows, the value of the firm remains the same, and so does the WACC. In reality, however, managers do worry about a firms capital structure. They try to find the mix that optimize firm value and to reduce its cost of capital. As a result, we observe different capital structures across industries. What is going on?
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This saving is usually valued by discounting at RD (the tax shield has the same risk as D). In the case of a perpetual debt,
VL=VU+TCD
=TC
TC D
WACC = R A =
D E RD (1 TC ) + RE V V
This means that WACC decreases in leverage. Value increases because we are discounting the cash flows with a lower WACC.
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D ( RU RD ) (1 TC ) E
The Static Theory of Capital Structure The Static Theory of Capital Structure
VL=VU+TCXD
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NPV = $1,000 +
PV (Bonds) =
PV (Shares) =
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Other Reasons for not Borrowing up to the Limit Other Reasons for not Borrowing up to the Limit
If the firm does not expect to use the extra tax shields arising from debt financing, then debt is not that attractive. Only high operating income firms have the need to use extremely high tax shields. There are also non-debt tax shields that reduce the need to rely on debt tax shields. These are depreciation and other expenses that are tax deductible.
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The Trade-Off Theory and Capital The Trade-Off Theory and Capital Structure Differences Across Industries Structure Differences Across Industries
Costs of distress vary with asset type: firms with tangible assets lose less value in bankruptcy than firms with intangible asset. High D/E firms: safe, tangible assets (utilities, retailers) Low D/E firms: risky, intangible assets (high-tech companies, pharmaceutical companies) Other issues: some highly profitable firms employ little debt, which contradicts the trade-off theory. These firms seem to follow a pecking order: internal funds are preferred to debt, and debt is preferred to equity.
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