Chapter 13 Capital Structure and Leverage 41913-4 CAPITAL STRUCTURE THEORY
Business risk is an important determinant of the optimal capital structure. More-
over,! rms in different industries have different business risks. So we would expect
capital structures to vary considerably across industries, and this is the case. For
example, pharmaceutical companies generally have very different capital struc-
tures than airlines. In addition, capital structures vary among! rms within a given
industry, which is a bit harder to explain. What factors can explain these differ-
ences? In an attempt to answer that question, academics and practitioners have
developed a number of theories.
Modern capital structure theory began in 1958 when Professors Franco Modi-
gliani and Merton Miller (hereafter, MM) published what has been called the most
in" uential! nance article ever written.^10 MM proved, under a restrictive set of
assumptions, that a! rm’s value should be unaffected by its capital structure. Put
another way, MM’s results suggest that it does not matter how a! rm! nances its
operations—hence, that capital structure is irrelevant. However, the assumptions
upon which MM’s study was based are not realistic, so their results are question-
able. Here is a partial listing of their assumptions:
- There are no brokerage costs.
- There are no taxes.
- There are no bankruptcy costs.
- Investors can borrow at the same rate as corporations.
- All investors have the same information as management about the! rm’s
future investment opportunities. - EBIT is not affected by the use of debt.
(^10) Franco Modigliani and Merton H. Miller, “The Cost of Capital, Corporation Finance, and the Theory of
Investment,” American Economic Review, June 1958. Both Modigliani and Miller won Nobel Prizes for their work.
is minimized at a 40% debt ratio. Thus, Bigbee’s optimal capital structure calls for
40% debt and 60% equity. Management should set its target capital structure at
these ratios; and if the existing ratios are off target, it should move toward that tar-
get when new securities are issued.
SEL
F^ TEST What happens to the component costs of debt and equity when the debt
ratio is increased? Why does this occur?
Using the Hamada equation, explain the e" ects of! nancial leverage on
beta.
What is the equation for calculating a! rm’s unlevered beta?
Use the Hamada equation to calculate the unlevered beta for Firm X
with the following data: bL " 1.25, T " 40%, Debt/Assets " 0.42, and
Equity/Assets " 0.58. (bU! 0.8714)
What would be the cost of equity for Firm X at Equity/Assets ratios of 1.0 (no
debt) and 0.58 assuming that rRF " 5% and RPM " 4%? (8.49%, 10%)
Using a graph and illustrative data, discuss the premiums for! nancial risk
and business risk at di" erent debt levels. Do these premiums vary depend-
ing on the debt level? Explain.
Is expected EPS generally maximized at the optimal capital structure?
Explain.