Chapter 16 Capital Structure- A firm's mix of long-term financing.

Modigliani and Miller (MM) Proposition- When there are no taxes and well functioning capital markets exist, the market value of a company does not depend on its capital structure. In other words, financial managers cannot increase the value by changing the mix of securities used to finance the company. Restructuring- Process of changing the firm`s capital structure without changing its assets. Does not affect operating income, regardless of the state of the economy. The value of a firm must be unaffected by its capital structure. MM`s Proposition 1 or Debt-irrelevance Proposition- The principle that the value of a firm is unaffected by its capital structure. Operating Risk- Also known as business risk, is risk in a firm`s operating income. Financial Leverage- Debt financing to amplify the effects of changes in operating income on the returns to stockholders. A firm that has issued debt is describe as a levered firm. Financial Risk- Risk to the shareholders resulting from the use of debt. MM's Proposition 2- The principle that the required rate of return on equity increases as the firm's debt-equity ratio increases. Debt increases financial risk and causes shareholders to demand a higher return on their investment. Once you recognize this implicit cost, debt is no cheaper than equity- the return that the investors require is unaffected by the firm's borrowing decision. Interest Tax Shield- Tax savings resulting from deductibility of interest payments. Annual tax shield= corporate tax rate x interest payment. Page 535, for examples of tax shields, and value of a levered firm. Cost of Financial Distress- Costs arising from bankruptcy or distorted business decisions before bankruptcy. At moderate debt levels, the probability of financial distress is trivial and therefore the tax advantages of debt dominate. But at some point the probability of financial distress increases rapidly with additional borrowing, and the potential costs of distress begin to take a substantial bite out of firm value. The theoretical optimum is reached when the present value of tax savings due to additional borrowing is just offset by the increases in the present value of costs of distress. Look at the slides for this area, not a lot in the textbook about it. Trade-off Theory- The idea that debt levels are chosen to balance the interest of tax shields against the costs of financial distress. Financial Distress- Is costly when conflicts get in the way of running the business. Shareholders are tempted to forsake the usual objective of maximizing the overall market value of the firm; the pursue their self-interests instead. They are tempted to play games at the expense of their creditors. These games add to the costs of financial distress. If the probability of default is high, managers will be tempted to take excessively risky projects. At the same time, shareholders might refuse to contribute more equity capital even if the firm has safe, positive-NPV opportunities. Shareholders would rather take money out of the firm than put new money in.

Loan Covenant- Agreement between firm and lender requiring the firm to fulfill certain conditions to safeguard the loan. Pecking-order Theory- Firms prefer to issue debt rather than equity if internal finance is insufficient. Financial Slack- Ready access to cash or debt financing. Bankruptcy- The reorganization of liquidation of a firm that cannot pay its debts. Workout- Agreement between a company and its creditors establishing the steps the company must take to avoid bankruptcy. Liquidation- Sale of a bankrupt firm's assets . Reorganization- Restructuring of financial claims on a failing firm to allow it to keep operating. More Summary questions on page 552.