Objectives

After reading this chapter, students should be able to:

1.  Explain why capital structure policy involves a trade-off between risk and return, and list the four primary factors that influence capital structure decisions.

2.  Distinguish between a firm’s business risk and its financial risk.

3.  Explain how operating leverage contributes to a firm’s business risk and conduct a breakeven analysis, complete with a breakeven chart.

4.  Define financial leverage and explain its effect on expected ROE, expected EPS, and the risk borne by stockholders.

5. Briefly explain what is meant by a firm’s optimal capital structure.

6. Specify the effect of financial leverage on beta using the Hamada equation, and transform this equation to calculate a firm’s unlevered beta, b_U.

7. Illustrate through a graph the premiums for financial risk and business risk at different debt levels.

8. List the assumptions under which Modigliani and Miller proved that a firm’s value is unaffected by its capital structure, then explain trade-off theory, signaling theory, and the effect of taxes and bankruptcy costs on capital structure.

9. List a number of factors or practical considerations firms generally consider when making capital structure decisions.

Specific Topics

• Risk/Return Trade-Off

• Business Risk vs. Financial Risk

• Operating Leverage

  • Break-Even Analysis

  • Breakeven Chart

• Financial Leverage

• Optimal Capital Structure

• Hamada Equation

• Capital Structure Theory

  • Modigliani and Miller's (MM's) Assumprions

  • Effects of Taxes and Bankruptcy Costs

  • Trade-Off Theory

  • Signaling Theory

• Factors affecting Capital Structure Decisions

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