In one way or another, business activity must be financed. Without finance to support
their fixed assets and working capital requirements, businesses could not exist. There are
three primary sources of finance for companies:
● a cash surplus from operating activities
● new equity funding
● borrowing from bank and non-bank sources. Non-bank sources are mainly investors in
the capital markets who subscribe for bonds and other securities issued by companies.
After studying this chapter in the lecture, you should be able to: Explain how financial leverage affects earnings per share (EPS) and return on equity (ROE), compute the degree of financial leverage, define and compute the indifference earnings before interest and taxes (EBIT) and explain its importance in selecting between alternative financing opportunities, define and explain the term homemade leverage, explain why determining the optimal capital structure is important,...
Strategic Corporate Finance provides a ‘‘real-world’’ application of the
principles of modern corporate finance, with a practical, investment
banking advisory perspective. Building on 15 years of corporate finance
advisory experience, this book serves to bridge the chronic gap between
corporate finance theory and practice. Topics range from weighted average
cost of capital, value-based management and M&A, to optimal capital
structure, risk management and dividend/buyback policy.
Strategic Corporate Finance provides a ‘‘real-world’’ application of the principles of modern corporate finance, with a practical, investment banking advisory perspective. Building on 15 years of corporate finance advisory experience, this book serves to bridge the chronic gap between corporate finance theory and practice. Topics range from weighted average cost of capital, value-based management and M&A, to optimal capital structure, risk management and dividend/buyback policy.
CHAPTER 13 Capital Structure and Leverage
Business vs. financial risk Optimal capital structure Operating leverage Capital structure theory
What is business risk?
Uncertainty about future operating income (EBIT), i.e., how well can we predict operating income?
Probability Low risk
Signaling approach Approach to the determination of the optimal capital structure asserting that insiders in a firm have information that the market does not have; therefore, the choice of capital structure by insiders can signal information to outsiders and change the value of the firm. This theory is also called the asymmetric information approach.
Numerous U.S. REITs and other institutions have invested in real property connected to
maquiladoras, retail development and tourism. This trend should persist because Mexico is ripe for
continued investment. With respect to retail development, for example, there are fewer than 1,000
malls and shopping centers in Mexico, which has a population of approximately 110 million
people. In comparison, there are more than 102,000 malls and shopping centers in the U.S., which
has a population of approximately 306 million people.
Options are not usually granted over the total value of the firm, but over the value of the
firm’s equity (i.e., the stock price). There are two ways to increase stock price volatility, and hence
stock options value. The first is to take on riskier projects (i.e., to increase risk on the left-hand side
of the firm's balance sheet at market values). The second is to increase leverage of the firm (i.e., to
increase risk on the right-hand side of the balance sheet). If firms are at an optimal capital structure,
deviations from that optimum are not value-creating and may...
Chapter 9 The Cost of Capital
a. The weighted average cost of capital, WACC, is the weighted average of the after-tax component costs of capital—-debt, preferred stock, and common equity. Each weighting factor is the proportion of that type of capital in the optimal, or target, capital structure.
Alternatively, banks may be optimising their capital structure, possibly much like non-
financial firms, which would relegate capital requirements to second order importance.
Flannery (1994), Myers and Rajan (1998), Diamond and Rajan (2000) and Allen et al. (2009)
develop theories of optimal bank capital structure, in which capital requirements are not
necessarily binding. Non-binding capital requirements are also explored in the market