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Lecture Fundamentals of financial management: Chapter 17 - Gregory A. Kuhlemeyer, Carroll College, Waukesha

This chapter explore the valuation underpinnings to the question of capital structure. As we shall see, much controversy surrounds the issue. Despite the unsettled nature of the matter, we hope that this presentation will provide the conceptual backdrop necessary to guide the financial manager in capital structure decisions. | Chapter 17 Capital Structure Determination © 2001 Prentice-Hall, Inc. Fundamentals of Financial Management, 11/e Created by: Gregory A. Kuhlemeyer, Ph.D. Carroll College, Waukesha, WI Capital Structure Determination A Conceptual Look The Total-Value Principle Presence of Market Imperfections and Incentive Issues The Effect of Taxes Taxes and Market Imperfections Combined Financial Signaling Capital Structure Concerned with the effect of capital market decisions on security prices. Assume: (1) investment and asset management decisions are held constant and (2) consider only debt-versus-equity financing. Capital Structure -- The mix (or proportion) of a firm’s permanent long-term financing represented by debt, preferred stock, and common stock equity. A Conceptual Look --Relevant Rates of Return ki = the yield on the company’s debt Annual interest on debt Market value of debt I B = = ki Assumptions: Interest paid each and every year Bond life is infinite Results in the valuation of a perpetual bond No taxes (Note: allows us to focus on just capital structure issues.) E S A Conceptual Look --Relevant Rates of Return = = ke = the expected return on the company’s equity Earnings available to common shareholders Market value of common stock outstanding ke Assumptions: Earnings are not expected to grow 100% dividend payout Results in the valuation of a perpetuity Appropriate in this case for illustrating the theory of the firm E S O V A Conceptual Look --Relevant Rates of Return = = ko = an overall capitalization rate for the firm Net operating income Total market value of the firm ko Assumptions: V = B + S = total market value of the firm O = I + E = net operating income = interest paid plus earnings available to common shareholders O V Capitalization Rate Capitalization Rate, ko -- The discount rate used to determine the present value of a stream of expected cash flows. ko ke ki B B + S S B + S = + What happens to ki, ke, and ko when leverage, B/S, increases? Net . | Chapter 17 Capital Structure Determination © 2001 Prentice-Hall, Inc. Fundamentals of Financial Management, 11/e Created by: Gregory A. Kuhlemeyer, Ph.D. Carroll College, Waukesha, WI Capital Structure Determination A Conceptual Look The Total-Value Principle Presence of Market Imperfections and Incentive Issues The Effect of Taxes Taxes and Market Imperfections Combined Financial Signaling Capital Structure Concerned with the effect of capital market decisions on security prices. Assume: (1) investment and asset management decisions are held constant and (2) consider only debt-versus-equity financing. Capital Structure -- The mix (or proportion) of a firm’s permanent long-term financing represented by debt, preferred stock, and common stock equity. A Conceptual Look --Relevant Rates of Return ki = the yield on the company’s debt Annual interest on debt Market value of debt I B = = ki Assumptions: Interest paid each and every year Bond life is infinite Results in the valuation of a .