Introduction to Corporate Finance

Ross et al.: Fundamentals

of Corporate Finance, Sixth

Edition, Alternate Edition

VI. Cost of Capital and

Long−Term Financial

Policy

17. Financial Leverage and
    Capital Structure Policy

© The McGraw−Hill^615

Companies, 2002

equity. Notice in Figure 17.7 that we have plotted the various capital costs against the

debt-equity ratio, D/E.

Figure 17.7 is much the same as Figure 17.5 except that we have added a new line for

the WACC. This line, which corresponds to the static theory, declines at first. This oc-

curs because the aftertax cost of debt is cheaper than equity, so, at least initially, the

overall cost of capital declines.

At some point, the cost of debt begins to rise, and the fact that debt is cheaper than

equity is more than offset by the financial distress costs. From this point, further in-

creases in debt actually increase the WACC. As illustrated, the minimum WACCoccurs

at the point D*/E*, just as we described before.

Optimal Capital Structure: A Recap

With the help of Figure 17.8, we can recap (no pun intended) our discussion of capital

structure and cost of capital. As we have noted, there are essentially three cases. We will

use the simplest of the three cases as a starting point and then build up to the static the-

ory of capital structure. Along the way, we will pay particular attention to the connec-

tion between capital structure, firm value, and cost of capital.

Figure 17.8 presents the original Modigliani and Miller no-tax, no-bankruptcy argu-

ment as Case I. This is the most basic case. In the top part of the figure, we have plotted

the value of the firm, VL, against total debt, D. When there are no taxes, bankruptcy costs,

or other real-world imperfections, we know that the total value of the firm is not affected

588 PART SIX Cost of Capital and Long-Term Financial Policy

FIGURE 17.7

Cost of

capital

(%)

Minimum

cost of

capital

Debt-equity ratio

D*/E* (D/E)

Optimal

debt-equity ratio

RD  (1 – TC)

WACC*

RE

RU

According to the static theory, the WACC falls initially because of the tax advantage of debt.

Beyond the point D* /E*, it begins to rise because of financial distress costs.

RU

WACC

The Static Theory of Capital Structure: The Optimal Capital Structure and the

Cost of Capital