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Level 127

Analysis of Capital Structure Theory

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Miller model
introduces the effect of personal taxes into the valuation of a levered firm, which reduces the advantage of corporate debt financing.
MM Proposition I with corporate taxes
VL = VU + TD. Thus, a firm's value increases with leverage and the optimal capital structure is virtually 100% debt.
MM Proposition I without taxes
VL = VU = EBIT/ rsu. Since both EBIT and rsu are constant, firm value is also constant and capital structure is irrelevant.
MM Proposition II with corporate taxes
rsL = rsu + (rsu - rd)(1 - …
MM Proposition II without taxes
rsL = rsu + (rsu - rd)(D/S). Thus, rs increase in a precise was as leverage increases. In fact, this increase is just sufficient to offset the increased use of lower-cost debt.
Financial distress costs
incurred when a leveraged firm facing a decline in earnings is forced to take actions to avoid bankruptcy. These costs may be the result of delays in the liquidation of assets, legal fees, the eff…
Agency costs
an expense, either direct or indirect, that is borne by a principle as a result of having delegated authority to an agent. An example is the costs borne by SHs to encourage managers to maxi…
Trade-off model
the addition of financial distress and agency costs to either the MM tax model or the Miller model. In this model, the optimal capital structure can be visualized as a trade-off between the benefi…
Value of debt tax shield
PV of the tax savings from the interest payments.
Equity as an option
when a firm has debt outstanding it can choose to default if the firm isn't worth ore than the face value of the debt; this decision to default when the value of the fir…