Capital Structure and Debt
Chapter 12
Capital Structure and Leverage
LEARNING OBJECTIVES
After reading this chapter, students should be able to:
• Explain why capital structure policy involves a trade-off between risk and return, and list the four primary factors that influence capital structure decisions.
• Distinguish between a firm’s business risk and its financial risk.
• Explain how operating leverage contributes to a firm’s business risk and conduct a breakeven analysis, complete with a breakeven chart.
• Define financial leverage and explain its effect on expected ROE, expected EPS, and the risk borne by stockholders.
• Briefly explain what is meant by a firm’s optimal capital structure.
• Specify the effect of financial leverage on beta using the Hamada equation, and transform this equation to calculate a firm’s unlevered beta, bU.
• Illustrate through a graph the premiums for financial risk and business risk at different debt levels.
• List the assumptions under which Modigliani and Miller proved that a firm’s value is unaffected by its capital structure, then explain trade-off theory, signaling theory, and the effect of taxes and bankruptcy costs on capital structure.
• List a number of factors or practical considerations firms generally consider when making capital structure decisions.
• Briefly explain the extent that capital structure varies across industries, individual firms in each industry, and different countries.
LECTURE SUGGESTIONS
This chapter is rather long, but it is also modular, hence sections can be omitted without loss of continuity. Therefore, if you are experiencing a time crunch, you could skip selected sections. Assuming you are going to cover the entire chapter, the details of what we cover, and the way we cover it, can be seen by scanning Blueprints, Chapter 12. For other suggestions about the lecture, please see the “Lecture Suggestions” in Chapter 2,
Capital Structure and Leverage
LEARNING OBJECTIVES
After reading this chapter, students should be able to:
• Explain why capital structure policy involves a trade-off between risk and return, and list the four primary factors that influence capital structure decisions.
• Distinguish between a firm’s business risk and its financial risk.
• Explain how operating leverage contributes to a firm’s business risk and conduct a breakeven analysis, complete with a breakeven chart.
• Define financial leverage and explain its effect on expected ROE, expected EPS, and the risk borne by stockholders.
• Briefly explain what is meant by a firm’s optimal capital structure.
• Specify the effect of financial leverage on beta using the Hamada equation, and transform this equation to calculate a firm’s unlevered beta, bU.
• Illustrate through a graph the premiums for financial risk and business risk at different debt levels.
• List the assumptions under which Modigliani and Miller proved that a firm’s value is unaffected by its capital structure, then explain trade-off theory, signaling theory, and the effect of taxes and bankruptcy costs on capital structure.
• List a number of factors or practical considerations firms generally consider when making capital structure decisions.
• Briefly explain the extent that capital structure varies across industries, individual firms in each industry, and different countries.
LECTURE SUGGESTIONS
This chapter is rather long, but it is also modular, hence sections can be omitted without loss of continuity. Therefore, if you are experiencing a time crunch, you could skip selected sections. Assuming you are going to cover the entire chapter, the details of what we cover, and the way we cover it, can be seen by scanning Blueprints, Chapter 12. For other suggestions about the lecture, please see the “Lecture Suggestions” in Chapter 2,