Chapter 9 Capital Structure. © 2005 Thomson/South-Western. The Target Capital Structure. Capital Structure: The combination of debt and equity used to finance a firm
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© 2005 Thomson/South-Western
Zero Debt Financing
50% Debt Financing
EPS ($)Probability Distribution of EPS with Different Amounts of Financial Leverage
All earnings paid out as dividends, so EPS = DPS.Assume that kRF = 6% and kM = 10%. Tax rate = 40%.
WACC = wdkd(1 - T) + wsks
= (D/A) kd(1 - T)+ (1 - D/A)ks
At D/A = 40%, WACC = 0.4[(10%)(1-.4)] + 0.6(14%) = 10.80%
Cost of Equity, ks
Debt/Assets (%)Relationship Between Capital Structure and Cost of Capital
Minimum = 10.8%
Maximum = $22.86
Debt/Assets (%)Relationship Between Capital Structure and Stock Price
3. Two levels of debt:
3. Between these two debt levels, the firm’s stock price rises, but at a decreasing rate
4. So, the optimal debt level = optimal capital structure
5. Many large, successful firms use much less debt than the theory suggests—leading to development of signaling theory.
Capital Structure Percentages for Selected Countries Ranked by Common Equity Ratios, 1995