Finance 571 Week 5 Summary

Finance 571 Week 5: Capital Structure

Week 5 of Finance 571 typically delves into the crucial topic of capital structure, exploring how companies determine the optimal mix of debt and equity financing to maximize firm value. The core question addressed is: Does capital structure matter, and if so, how can firms strategically manage it?

Key Concepts Covered

Several fundamental concepts are usually examined in detail:

Modigliani-Miller (MM) Theorem: This cornerstone theory, initially presented without taxes, argues that in a perfect market (no taxes, bankruptcy costs, or information asymmetry), a firm’s value is independent of its capital structure. This serves as a baseline to understand how imperfections influence real-world capital structure decisions.
MM Theorem with Taxes: Introducing corporate taxes changes the equation. Debt financing becomes advantageous due to the tax deductibility of interest payments, creating a “tax shield” that increases firm value. This suggests that firms should theoretically maximize debt.
Trade-off Theory: This theory acknowledges the benefits of debt’s tax shield but also incorporates the costs of financial distress. As a firm takes on more debt, the probability of bankruptcy and associated costs (e.g., legal fees, loss of customers, fire sales) increase. The optimal capital structure balances the tax benefits against the costs of financial distress, aiming to minimize the weighted average cost of capital (WACC).
Pecking Order Theory: This theory suggests that firms prefer internal financing (retained earnings) over external financing, and when external financing is needed, they prefer debt over equity. This hierarchy stems from information asymmetry – managers know more about the firm’s prospects than investors. Issuing equity signals that the firm’s stock might be overvalued, leading to a negative market reaction.
Agency Costs: These arise from the separation of ownership (shareholders) and management (managers). Debt can help mitigate agency costs by forcing managers to be more disciplined and generate sufficient cash flow to meet debt obligations. However, excessive debt can also lead to underinvestment problems, as managers may avoid risky but potentially profitable projects to ensure debt repayment.
Factors Influencing Capital Structure Decisions: Beyond the theoretical frameworks, the week often covers practical factors affecting real-world decisions, such as industry norms, firm size, growth opportunities, asset tangibility, and management risk aversion.

Learning Objectives

By the end of Week 5, students should be able to:

Understand the theoretical foundations of capital structure, including the MM theorems and trade-off theory.
Analyze the advantages and disadvantages of debt and equity financing.
Evaluate the impact of taxes, bankruptcy costs, and agency costs on capital structure decisions.
Apply capital structure theories to real-world scenarios.
Calculate a firm’s optimal capital structure based on its specific circumstances.

Assignments and Activities

Typical assignments for this week may include problem sets applying the MM theorem and trade-off theory, case studies analyzing real companies’ capital structure choices, and discussions on the relevance and limitations of the theoretical models. Students are often expected to critically evaluate how companies balance the various factors influencing their financing decisions.