MGFC10H3 Chapter 17: Chapter 17 Notes
Document Summary
Chapter 17 capital structure: limits to the use of debt notes. 17. 4 integration of tax effects and financial distress costs. Pie again the pie theory says that all of these claims are paid from only one source, the cash flows (cf) of the firm. According to the trade-off model, each firm balances the benefits of debt, such as the tax shield, with the costs of debt, such as distress costs. The optimal amount of leverage occurs where the marginal benefit of debt equals the marginal cost of debt. By contrast, the pecking-order theory does not imply a target amount of leverage. Rather, each firm chooses its leverage ratio based on financing needs. Firms first fund projects out of retained earnings. This should lower the percentage of debt in the capital structure, because profitable, internally funded projects raise both the book value and the market value of equity. Additional cash needs are met with debt, clearly raising the debt level.
