3FA3-CH16.docx

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Commerce 3FA3
Chapter 16: Financial leverage and capital structure policy
Definitions
M&M Proposition 1: The value if the firm is independent of its capital structure
M&M Proposition II: A firm’s cost of equity capital is a positive linear function as capital structure
Business risk: The equity risk that comes from the nature of the firm’s operating activities
Financial risk: The equity risk that comes from the financial policy of the firm
Interest tax shield: The tax saving attained by a firm from interest expense
Unlevered cost of capital: The cost of capital of a firm that has no debt
Direct bankruptcy costs: The costs that are directly associated with bankruptcy, such as legal
and administrative expenses
Indirect bankruptcy costs: The difficulties of running a business that is experiencing financial
distress
Financial distress costs: The direct and indirect costs associated with going bankrupt or
experiencing financial distress
Static theory of capital structure: Theory that a firm borrows up to the point where the tax
benefit from an extra dollar is exactly equal to the cost that comes from the increased probability
of financial distress
Bankruptcy: A legal proceeding for liquidating or reorganizing a business. Also, the transfer of
some or all of a firm’s assets to its creditors
- One of the consequences of using debt is the possibility of financial distress, which can be
defined in several ways: Business failure, legal bankruptcy, technical insolvency, and accounting
insolvency
Liquidation: Termination of the firm as a going concern
Reorganization: Financial restructuring of a failing firm to attempt to continue operations as a
going concern
Summary and Conclusions
- The ideal mixture of debt and equity (its optimal capital structure) is the one that maximizes the
value of the firm and minimizes the overall cost of capital
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