In this chapter, you will learn: Explain the effects of financial leverage, distinguish between business risk and financial risk, understand the ‘capital structure irrelevance’ theory of Modigliani and Miller (MM), explain the roles of taxes and other factors that may influence capital structure decisions, | Chapter 13 Principles of Capital Structure 2 2 2 2 2 2 2 2 2 2 2 2 2 Learning Objectives Explain the effects of financial leverage. Distinguish between business risk and financial risk. Understand the ‘capital structure irrelevance’ theory of Modigliani and Miller (MM). Explain the roles of taxes and other factors that may influence capital structure decisions. 2 2 2 2 2 2 2 2 2 2 2 2 2 Learning Objectives (cont.) Understand the concept of an optimal capital structure, based on a trade-off between the benefits and costs of using debt. Explain the ‘pecking order’ theory of capital structure. Outline Jensen’s free cash flow theory. 3 3 3 3 3 3 3 3 3 3 3 3 3 Introduction Capital structure The mix of debt and equity finance used by a company. Optimal capital structure The capital structure which maximises the value of a company. Does the value of the net operating cash flow stream depend on how it is divided between payments to lenders and shareholders? 4 4 4 4 4 4 4 4 4 4 4 4 4 . | Chapter 13 Principles of Capital Structure 2 2 2 2 2 2 2 2 2 2 2 2 2 Learning Objectives Explain the effects of financial leverage. Distinguish between business risk and financial risk. Understand the ‘capital structure irrelevance’ theory of Modigliani and Miller (MM). Explain the roles of taxes and other factors that may influence capital structure decisions. 2 2 2 2 2 2 2 2 2 2 2 2 2 Learning Objectives (cont.) Understand the concept of an optimal capital structure, based on a trade-off between the benefits and costs of using debt. Explain the ‘pecking order’ theory of capital structure. Outline Jensen’s free cash flow theory. 3 3 3 3 3 3 3 3 3 3 3 3 3 Introduction Capital structure The mix of debt and equity finance used by a company. Optimal capital structure The capital structure which maximises the value of a company. Does the value of the net operating cash flow stream depend on how it is divided between payments to lenders and shareholders? 4 4 4 4 4 4 4 4 4 4 4 4 4 Effects of Financial Leverage Business risk The variability of future net cash flows attributed to the nature of the company’s operations (the risk faced by shareholders if the company is financed only by equity). Financial risk The risk attributable to the use of debt as a source of finance. 5 5 5 5 5 5 5 5 5 5 5 5 Effects of Financial Leverage (cont.) Effects of financial leverage: Expected rate of return on equity is increased. Variability of returns to shareholders increases. Increasing leverage involves a trade-off between risk and return. 6 6 6 6 6 6 6 6 6 6 6 6 6 Effects of Financial Leverage (cont.) Measures of financial leverage: Debt to equity, debt to total assets and interest coverage. Leverage varies both within and between industries. For example, in 2004, Woolworths had positive net debt ratios, while David Jones had negative net debt ratios, even though they were both in the same industry. 6 6 6 6 6 6 6 6 6 6 6 6 6 Modigliani & Miller Analysis Assumptions Capital .
