Page 114 - DMGT409Basic Financial Management

Unit 6: Capital Structure Theory

Notes
2. Fully debt capital plan,
3. Fully preference share capital plan,
4. Combination of (a) and (b) in different proportions,

5. A combination of (a), (b) and (c) in different proportions, and
6. A combination of (a) and (c) in different proportions and so on.

Of all the sources of long-term finance, debt is the cheapest source no doubt, because the
interest paid on debt is allowed for tax purpose. The company can save tax due to the
interest, but company cannot use debt beyond certain limit, up to certain limit use of debt
reduces overall cost of capital; beyond the limit it will increase. This can be illustrated with
the following example.
Finance source and their cost Plan 1 Plan 2 Plan 3 Plan 4 Plan 5 Plan 6 Plan 7
Debt as a percentage of total capital 0 10 20 30 40 50 60
Debt cost (Kd %) 7 7 7 7.5 8 8.5 9.5
Cost of Equity (Ke %) 15 15 15.5 16 17 19 20

You are required to find out optimal debt-equity mix of the company.

6.7 The Trade off Theory: Cost of Financial Distress and Agency Cost

As the debt equity ratio (ie leverage) increases, there is a trade-off between the interest tax shield
and bankruptcy, causing an optimum capital structure, D/E*
The Trade-Off Theory of Capital Structure is a theory in the realm of Financial Economics about

the corporate finance choices of corporations. Its purpose is to explain the fact that fi rms or

corporations usually are financed partly with debt and partly with equity. It states that there is an

advantage to financing with debt, the tax benefit of debt and there is a cost of financing with debt,

the costs of fi nancial distress including bankruptcy costs of debt and non-bankruptcy costs e.g.
staff leaving, suppliers demanding disadvantageous payment terms, bondholder/stockholder
infi ghting, etc.
Trade-Off Model

Financial distress costs (includes bankruptcy)
1. Direct costs: Lawyer’s fees, court costs, administrative expenses, assets disappear or
become obsolete
2. Indirect costs: Managers make short-run decisions; customers and suppliers may impose
costs

Agency costs

More debt is likely to be experienced. Distress stockholders (thus management) want risk, while
bondholders do not.
Use covenants to align interests costs: monitoring to ensure they are followed; also may hamper
business. In essence, lost efficiency and monitoring costs reduce advantage of debt, given agency

costs and fi nancial distress.
VL = VU + TD – (PV of expected costs of financial distress) – (PV of agency costs)

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