Capital Structure and Dividend Policy

Latest Revision: January 4, 1997

10.0 Objectives:

After completing this class, you should be able to:

• Compute the firm’s Weighted Average Cost of Capital (WACC) when there are no taxes and when there are corporate taxes.

10.1 Introduction

In this class we address the question of how a firm should raise funds to finance its investments. There are two alternative classes of the source of funds.

Equity funds can be raised by issuing shares to shareholders who then have an ownership interest in the firm. Debt funds can be raised by borrowing from a bank or by issuing bonds. The lenders or bondholders have a creditor relationship with the firm. The firm’s financing decision is whether to raise all funds by equity issues; to use only debt issues; or, to use a combination of the two. Under standard economic assumptions the combination of debt and equity chosen by a firm does not affect the market value of the firm. That is the debt/equity decision is irrelevant to the value of the firm. This is the famous Modigliani and Miller irrelevance proposition. one of the cornerstones of modern finance.

When standard economic assumptions are relaxed to include corporate taxes, and in particular deductibility of interest expenses for tax purposes, then a levered firm (one with debt) will always be worth more than an unlevered firm. When personal taxes are admitted in addition to corporate taxes there are a wide range of circumstances under which the tax advantage of debt disappears and we can arrive back at the Modigliani and Miller irrelevance proposition.

Since the notation becomes quite extensive when examining these issues, we begin with a reference table that defines the various symbols used in the analysis. The terms in the table are defined throughout the text. In general, the superscript denotes whether the symbol applies to a levered or an unlevered firm and the subscript refers to whether the symbol applies to (1) stocks or bonds, or (2) the existing assets of the firm or the new project under consideration, and so on.