Capital Structure & Financial Leverage Cheat Sheet

Understand how a firm's mix of debt and equity financing impacts its value, cost of capital, and shareholder returns, considering various theoretical frameworks.

Core Principles

• Capital structure is the mix of debt and equity a firm uses to finance its assets.
• The guiding principle for capital structure decisions is to maximize shareholder wealth.
• Financial leverage amplifies both the potential gains and losses for shareholders.
• The Modigliani-Miller theorems provide foundational insights into capital structure irrelevance (without taxes) and the impact of taxes.
• The Static Trade-off Theory suggests an optimal capital structure balances tax benefits against financial distress costs.

Action Steps

• Analyze the firm's current capital structure (debt-to-equity ratio).
• Evaluate the impact of potential changes in leverage on EPS and ROE.
• Consider the Modigliani-Miller propositions regarding taxes and bankruptcy costs.
• Assess the trade-off between tax shields and the costs of financial distress.
• Determine the optimal capital structure that maximizes firm value.

Formulas

• $V = E + D$
• $Firm Value, V = \frac{CFFA}{WACC}$
• $WACC = \frac{E}{V} \times R_E + \frac{D}{V} \times R_D$
• $R_E = R_A + (R_A - R_D) \times \frac{D}{E}$
• $V_L = V_U + D \times T_c$
• $V_L = V_U + D \times T_c - PV(Cost \ of \ Financial \ Distress)$
• $Interest \ Tax \ Shield = D \times R_D \times T_c$

Key Terms

• Capital Structure: The specific combination of debt and equity a company uses to finance its operations and growth.
• Financial Leverage: The extent to which a firm relies on debt financing. It magnifies returns but also increases risk.
• WACC: Weighted Average Cost of Capital. The average rate a company expects to pay to finance its assets.
• Modigliani-Miller Theorem: A set of theorems stating that, under certain conditions, the value of a firm is independent of its capital structure.
• Interest Tax Shield: The reduction in taxes a firm achieves due to the tax deductibility of interest payments on debt.
• Financial Distress Costs: Costs incurred by a firm when it experiences financial difficulties, including direct (legal, administrative) and indirect (lost sales, damaged reputation) costs.

People

• Franco Modigliani: Nobel Laureate, Economist; Co-developer of the Modigliani-Miller Theorem.
• Merton Miller: Nobel Laureate, Economist; Co-developer of the Modigliani-Miller Theorem.