Lecture 8: Debt Policy & Optimal Capital Structure
4 views 0 purchase
Course
MN10500: Corporate Finance for Managers (MN10500)
Institution
University Of Bath (UoB)
Lecture Summary
● The trade-off between debt and equity.
○ Benefits
○ Costs
● Alternative capital structure theories and empirical evidence.
● The (simplified) cost of capital model to determine the optimal debt-equity
combination that minimises WACC.
MN10500 Lecture 8: Debt Policy & Optimal Capital Structure
Lecture Summary
● The trade-off between debt and equity.
○ Benefits
○ Costs
● Alternative capital structure theories and empirical evidence.
● The (simplified) cost of capital model to determine the optimal debt-equity
combination that minimises WACC.
Long-Term Finance Preference: Survey Preferences
More Evidence: European SMEs
Source: European Commission (2014)
Patterns of Debt Finance
Market debt ratio is more volatile.
, 05/04
Costs & Benefits of Debt
● Costs of debt
○ Bankruptcy Costs
○ Agency Costs
○ Loss of Future Flexibility
● Benefits of debt
○ Tax Benefits
○ Adds discipline to management
○ Adds leverage to Capital Structure
Tax Benefits of Debt
● When you borrow money, you are allowed to deduct interest expenses from your
income to arrive at taxable income. This reduces your taxes. When you use equity,
you are not allowed to deduct payments to equity (such as dividends) to arrive at
taxable income.
● The dollar tax benefit from interest payment in any year is a function of your tax rate
and the interest payment.
● Proposition 1: Other things being equal, the higher the marginal tax rate of a
business, the more debt it will have in its capital structure.
● D/E = 1.54, recall from L7 (slide 14) that D/V = (D/E) / [1 + (D/E)] = 1.54 / (1 + 1.54) =
0.6063
● A shortcut: D/E = 1.54 so pretend D = 1.54 and E = 1 (we are calculating ratios, so
the real numbers of D and E don’t matter), so D/(D+E) = 1.54/(1.54+1), E/(D+E) =
1/(1.54+1).
Debt adds Discipline to Management
● If you are a manager of a firm with no debt, and you generate high income and cash
flows each year, you tend to become complacent. The complacency can lead to
The benefits of buying summaries with Stuvia:
Guaranteed quality through customer reviews
Stuvia customers have reviewed more than 700,000 summaries. This how you know that you are buying the best documents.
Quick and easy check-out
You can quickly pay through credit card or Stuvia-credit for the summaries. There is no membership needed.
Focus on what matters
Your fellow students write the study notes themselves, which is why the documents are always reliable and up-to-date. This ensures you quickly get to the core!
Frequently asked questions
What do I get when I buy this document?
You get a PDF, available immediately after your purchase. The purchased document is accessible anytime, anywhere and indefinitely through your profile.
Satisfaction guarantee: how does it work?
Our satisfaction guarantee ensures that you always find a study document that suits you well. You fill out a form, and our customer service team takes care of the rest.
Who am I buying these notes from?
Stuvia is a marketplace, so you are not buying this document from us, but from seller suprajasaravanan. Stuvia facilitates payment to the seller.
Will I be stuck with a subscription?
No, you only buy these notes for $4.54. You're not tied to anything after your purchase.
