Chapter 15 study guide

CAPITAL STRUCTURE

Topical review

• Differentiate business risk and financial risk
• Explain some factors that impact business risk
• Discuss the benefits and drawbacks of using debt financing
• Work through a recapitalization example
  
  • Estimate cost of equity as debt increases - Hamada equation
  • Value the equity as a perpetuity - assuming no growth (like Pizza Palace)
  • Evaluate the equilibrium stock price
  • Establish the optimal capital structure as maximum share price/minimum WACC
• Describe the evolution of capital structure theory
  
  • Modigliani and Miller
    
    • Assumptions
    • Capital structure irrelevance (MM I)
  • Relax MM assumptions
    
    • Introduction of corporate taxes - value of tax shield
    • Financial distress costs - trade-off theory
    • Signalling/asymmetric information - maintain borrowing capacity
  • Other issues
    • Pecking order
    • Managerial discipline - agency costs
• Identify important factors that are relevant to capital structure decision (checklist at end of chapter)
  

Definitions

• Basic concepts Business risk, financial risk, optimal capital structure, levered vs. unlevered beta
• Theory - trade-off theory, reserve borrowing capacity, pecking order, direct vs. indirect costs of financial distress, signalling, homogeneous expectations, asymmetric information, 

Numerical problems from textbook
ST-1, #2/3, 10