Question

If we incorporate Financial Distress or Bankruptcy Costs and also Taxes, then we have altered the fundamental assumptions of Modigliani and Miller. Explain the relationship between leverage and capital structure under the new assumptions.

Answer 1

A high debt/equity ratio generally means that a company has been aggressive in financing its growth with debt. This can result in volatile earnings as a result of the additional interest expense.

If a lot of debt is used to finance increased operations (high debt to equity), the company could potentially generate more earnings than it would have without this outside financing. If this financing increases earnings by a greater amount than the debt cost (interest), then the shareholders benefit as more earnings are being spread among the same amount of shareholders. However, the cost of this debt financing may outweigh the return that the company generates on the debt through investment and business activities and become too much for the company to handle. Insufficient returns can lead to bankruptcy and leave shareholders with nothing.

The debt/equity ratio also depends on the industry in which the company operates. For example, capital-intensive industries such as auto manufacturing tend to have a debt/equity ratio above 2, while personal computer companies tend to have a debt/equity ratio of under 0.5. (Read more inSpotting Companies In Financial DistressandDebt Ratios: Introduction.)A company can change its capital structure by issuing debt to buy back outstanding equities or by issuing new stock and using the proceeds to repay debt. Issuing new debt increases the debt-to-equity ratio; issuing new equity lowers the debt-to-equity ratio.

As you will recall from Section 13 of this walkthrough, minimizing theweighted average cost of capital(WACC) maximizes the firm's value. This means that the optimal capital structure for a firm is the one that minimizes WACC.

In this section, we'll go into the details of a firm's capital structure, financial leverage, theoptimal capital structureand real-world capital structures. We'll also talk about financial distress and bankruptcy, andModiglianiandMiller's ideas about capital structure and firm value when taking corporate taxes into account