Page 18 - FINAL CFA II SLIDES JUNE 2019 DAY 6

MM Proposition II (No Taxes): Cost of Equity and Leverage READING 21: CAPITAL STRUCTURE
Proposition:

MODULE 21.1: THEORIES OF CAPITAL STRUCTURE

Debt holders have MM Proposition II (With Taxes): WACC
a priority claim on Is Minimized at 100% Debt:
assets and
income, which
makes the cost of
debt lower than
the cost of equity
but cost of debt
are unchanged.

The tax shield provided by debt
causes the WACC to decline as
leverage increases.

The value of the firm is
maximized at the point where
the WACC is minimized, which
is 100% debt.

All MM ignore costs with serious potential effect on the Capital Structure…
Costs of financial distress increase when earnings decline and the firm has trouble paying its fixed financing costs (i.e., interest on debt): 2 components:
• Direct: cash expenses associated with the bankruptcy, such as legal fees and administrative fees.
• Indirect: foregone investment opportunities and costs resulting loss of goodwill with customers, creditors, suppliers, and employees.

Probability of financial distress is directly related to the firm’s use of financial (versus operating) leverage. Other factors include the quality of management
and corporate governance structure!

1. Monitoring costs -supervising management, governance reporting, board of directors.
Agency costs of equity – 2. Bonding costs incurred to re-assure shareholders (e.g. insurance premiums to guarantee performance and non-compete agreements).
3. Residual losses if above do not work.
Use of debt to force managers to be disciplined on cash management..