TAILIEUCHUNG - Financial Management - Chapter 16

In a “perfect world” environment with no taxes, no transaction costs and perfectly efficient financial markets, capital structure does not matter. This is known as the Independence hypothesis: firm value is independent of capital structure. | Chapter 16: Planning the Firm’s Financing Mix How do we want to finance our firm’s assets? Common Equity Debt Preferred 2002, Prentice Hall, Inc. 1 Balance Sheet Current Current Assets Liabilities Debt and Fixed Preferred Assets Shareholders’ Equity 2 Balance Sheet Current Current Assets Liabilities Debt and Fixed Preferred Assets Shareholders’ Equity 3 Balance Sheet Current Current Assets Liabilities Debt and Fixed Preferred Assets Shareholders’ Equity Financial Structure 4 Balance Sheet Current Current Assets Liabilities Debt and Fixed Preferred Assets Shareholders’ Equity 3 Balance Sheet Current Current Assets Liabilities Debt and Fixed Preferred Assets Shareholders’ Equity Capital Structure 3 Why is Capital Structure Important? 1) Leverage: higher financial leverage means higher returns to stockholders, but higher risk due to interest payments. 2) Cost of Capital: Each source of financing has a different cost. Capital structure affects the cost of capital. 3) The Optimal Capital Structure is the one that minimizes the firm’s cost of capital and maximizes firm value. What is the Optimal Capital Structure? In a “perfect world” environment with no taxes, no transaction costs and perfectly efficient financial markets, capital structure does not matter. This is known as the Independence hypothesis: firm value is independent of capital structure. 8 Independence Hypothesis Firm value does not depend on capital structure. 9 Cost of Capital kc 0% debt financial leverage 100%debt . kc = cost of equity kd = cost of debt ko = cost of capital Independence Hypothesis 10 . Independence Hypothesis Cost of Capital kc kd kd 0% debt financial leverage 100%debt 17 . Independence Hypothesis Cost of Capital kc kd kd 0% debt financial leverage 100%debt 17 Increasing leverage causes the cost of equity to rise. Independence Hypothesis Cost of Capital kc kd kd 0% debt financial leverage 100%debt 17 Independence Hypothesis Cost of Capital kc kd kc kd Increasing leverage causes the cost

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