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Contemporary Financial

Management

Capital Structure Concepts

Introduction

This chapter examines the basic conceptsrelated to a firm’s optimal capital structure.

Capital vs. Financial Structure

Capital Structure

Amount of permanent short-term debt, long-term debt, preferred shares and common equity usedto finance the firm.

Financial Structure

Amount of current liabilities, long-term debt, preferred shares and common equity used tofinance a firm.

Capital Structure Terminology

Optimal capital structure

Minimizes a firm’s weighted average cost of capital(WACC) - Maximizes the value of the firm - Target capital structure - Capital structure the firm plans to maintain - Debt capacity - Amount of debt in the firm’s optimal capital structure

Factors Affecting Capital Structure

Business risk of the firm

Tax structure

Bankruptcy potential

Agency costs

Signaling effects

Factors Affecting Business Risk

Variability of sales volume

Variability of selling price - Variability of input costs - Degree of market power - Extent of product diversification - Firm’s growth rate - Degree of operating leverage (DOL) - Both systematic and unsystematic risk

Three Capital Structure Models

Capital Structure With No Taxes Optimal Capital Structure With Taxes Optimal Capital Structure With Taxes, Financial Distress Costs & Agency Costs