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^619

Companies, 2002

Marketed Claims versus Nonmarketed Claims

With our extended pie model, there is an important distinction between claims such as

those of stockholders and bondholders, on the one hand, and those of the government

and potential litigants in lawsuits on the other. The first set of claims are marketed

claims,and the second set are nonmarketed claims.A key difference is that the marketed

claims can be bought and sold in financial markets and the nonmarketed claims cannot.

When we speak of the value of the firm, we are generally referring to just the value

of the marketed claims, VM, and not the value of the nonmarketed claims, VN. If we write

VTfor the total value of all the claims against a corporation’s cash flows, then:

VTEDGB...

VMVN

The essence of our extended pie model is that this total value, VT, of all the claims to the

firm’s cash flows is unaltered by capital structure. However, the value of the marketed

claims, VM, may be affected by changes in the capital structure.

Based on the pie theory, any increase in VMmust imply an identical decrease in VN.

The optimal capital structure is thus the one that maximizes the value of the marketed

claims, or, equivalently, minimizes the value of nonmarketed claims such as taxes and

bankruptcy costs.

CONCEPT QUESTIONS

17.7a What are some of the claims to a firm’s cash flows?

17.7bWhat is the difference between a marketed claim and a nonmarketed claim?

17.7c What does the extended pie model say about the value of all the claims to a

firm’s cash flows?

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

FIGURE 17.9

Lower financial leverage Higher financial leverage

Bondholder

claim

Stockholder

claim

Bankruptcy

claim

Tax

claim

Bondholder

claim

Stockholder

claim Bankruptcy

claim

Tax

claim

In the extended pie model, the value of all the claims against the firm’s cash flows is not

affected by capital structure, but the relative values of claims change as the amount of

debt financing is increased.

The Extended Pie Model Slide17.36