CHAPTER SEVENTEEN DOES DEBT POLICY MATTER? When the firm is financed entirely by common stock, all those cash flows belong to the stockholders. When it issues both debt and equity securities, it undertakes to split up the cash flows into two streams, a relatively safe stream that goes to the debtholders | Brealey-Meyers Principles of Corporate Finance Seventh Edition V. Dividend Policy and Capital Structure The McGraw-Hill Companies 2003 17. Does Debt policy Matter CHAPTER EVENTEEN DOE DEB POLICY matter 464 Brealey-Meyers Principles of Corporate Finance Seventh Edition V. Dividend Policy and Capital Structure 17. Does Debt policy Matter The McGraw-Hill Companies 2003 A FIRM S BASIC resource is the stream of cash flows produced by its assets. When the firm is financed entirely by common stock all those cash flows belong to the stockholders. When it issues both debt and equity securities it undertakes to split up the cash flows into two streams a relatively safe stream that goes to the debtholders and a more risky one that goes to the stockholders. The firm s mix of different securities is known as its capital structure. The choice of capital structure is fundamentally a marketing problem. The firm can issue dozens of distinct securities in countless combinations but it attempts to find the particular combination that maximizes its overall market value. Are these attempts worthwhile We must consider the possibility that no combination has any greater appeal than any other. Perhaps the really important decisions concern the company s assets and decisions about capital structure are mere details matters to be attended to but not worried about. Modigliani and Miller MM who showed that dividend policy doesn t matter in perfect capital markets also showed that financing decisions don t matter in perfect Their famous proposition I states that a firm cannot change the total value of its securities just by splitting its cash flows into different streams The firm s value is determined by its real assets not by the securities it issues. Thus capital structure is irrelevant as long as the firm s investment decisions are taken as given. MM s proposition I allows complete separation of investment and financing decisions. It implies that any firm could use the capital .
