Page 18 - FINAL CFA II SLIDES JUNE 2019 DAY 6

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

MODULE 21.1: THEORIES OF CAPITAL STRUCTURE

Debt holders have MM Proposition II (With Taxes): WACC Is Minimized at 100% Debt: If we
a priority claim on assume the marginal tax rate is not zero and then use the WACC formula to solve
assets and for return on equity, we get MM Proposition II (With Taxes):
income, which
makes the cost of
debt lower than
the cost of equity
but cost of debt The tax shield
are unchanged. 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.

Costs and Their Potential Effect on the Capital Structure
Costs of financial distress are the increased costs a company faces when earnings decline and the firm has trouble paying its fixed
financing costs (i.e., interest on debt): 2 components:
• Direct: includes the cash expenses associated with the bankruptcy, such as legal fees and administrative fees.
• Indirect: includes foregone investment opportunities and the costs that result from losing the trust of 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!