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Capital Structure Answers

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21 views2 pages

Capital Structure Answers

Uploaded by

tajdikul
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Capital Structure Questions and

Answers
Question 1: Does Capital Structure Matter?
The capital structure of a firm refers to the mix of debt and equity that a company uses to
finance its operations and growth. According to Modigliani and Miller's (M&M) Proposition
I (without taxes), under perfect market conditions, the capital structure does not affect the
total market value of the firm's securities. In a world with no taxes, no transaction costs, and
symmetric information, the market value of the firm is determined by the firm's earning
power and the risk of its underlying assets, rather than how it finances itself.

However, in the real world where taxes, bankruptcy costs, agency problems, and
asymmetric information exist, capital structure does matter. Factors such as tax shields on
interest payments, the cost of financial distress, and agency costs all influence the firm's
market value. Increasing the proportion of debt in the capital structure can initially increase
the value of the firm because of tax benefits on interest payments (i.e., interest tax shields).
However, too much debt can increase the probability of financial distress, leading to higher
bankruptcy costs, reducing the firm’s value. Therefore, the mix of debt and equity can either
increase or decrease the firm’s market value.

Question 2: What Determines the Optimal Mix of Debt and Equity?


If capital structure matters, the optimal mix of debt and equity that maximizes a firm’s
market value is determined by several factors:

1. **Tax Benefits (Interest Tax Shields):** Debt financing provides tax shields because
interest payments on debt are tax-deductible, which can lower the overall tax liability of the
firm, thereby increasing its value. Firms in higher tax brackets may benefit more from debt.

2. **Cost of Financial Distress:** As firms increase their leverage (debt levels), they also
increase the risk of financial distress. High levels of debt can lead to bankruptcy costs, both
direct (legal and administrative expenses) and indirect (lost sales, reputation damage),
which may outweigh the benefits of tax shields.

3. **Agency Costs:** Debt can act as a disciplining mechanism on management by reducing


free cash flow and forcing managers to focus on efficient operations. However, excessive
debt can also lead to conflicts between equity holders and debt holders, increasing agency
costs.

4. **Asymmetric Information:** The pecking order theory suggests that firms prefer
internal financing, followed by debt, and finally equity. Issuing equity might signal to the
market that the firm's stock is overvalued, leading to a drop in stock price, whereas debt
issuance may have a less negative impact.

5. **Growth Opportunities:** Firms with higher growth opportunities may prefer equity
over debt because debt requires fixed payments, which can strain resources needed for
future growth. In contrast, mature firms with stable cash flows may prefer debt to benefit
from tax shields.

6. **Market Conditions:** Firms often adjust their capital structure based on prevailing
interest rates and investor sentiment in equity markets. Favorable debt markets (low
interest rates) may encourage firms to issue more debt, while buoyant equity markets
might encourage issuing stock.

The optimal capital structure is a balance between these factors, aiming to maximize firm
value and minimize the cost of capital, including the cost of equity.

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