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

(^616) © The McGraw−Hill
Companies, 2002

FIGURE 17.8

Value

of the

firm

(VL)

Total

debt (D)

VU Case I

M&M (no taxes)

Weighted

average

cost of

capital (%)

Debt-equity

ratio (D/E)

RU

Case I

M&M (no taxes)

Case I

With no taxes or bankruptcy costs, the value of the firm and its weighted average cost of

capital are not affected by capital structures.

Case II

With corporate taxes and no bankruptcy costs, the value of the firm increases and the weighted

average cost of capital decreases as the amount of debt goes up.

Case III

With corporate taxes and bankruptcy costs, the value of the firm, VL, reaches a maximum at

D*, the point representing the optimal amount of borrowing. At the same time, the weighted

average cost of capital, WACC, is minimized at D*/E*.

Case II

M&M (with taxes)

Case II

M&M (with taxes)

D*/E*

Net saving from

leverage Case III

Static theory

Case III

Static theory

D*

PV of bankruptcy

costs

Net gain from leverage

WACC*

VL*

The Capital Structure Question

589