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2022 | OriginalPaper | Chapter

10. Debt, Equity, the Optimal Financial Structure, and the Cost of Funds

Authors : John B. Guerard Jr., Anureet Saxena, Mustafa N. Gültekin

Published in: Quantitative Corporate Finance

Publisher: Springer International Publishing

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Abstract

Traditionally the capital structure of a firm has been defined as the book value of its common stock, its preferred stock, and its bonds, or fixed liabilities. These items are considered to be the “permanent” financing of the firm. The special importance is given to them, however, which may lead to an error in financial analysis. Thus, a company which only has common shares in its capital structure is often described as conservatively or safely financed. But if, for example, the firm has considerable trade debt outstanding, owes on a bank loan, or is tied up with long-run rental contracts, it may not be “safely” financed.

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previous chapter Long-Term Debt

next chapter Investing in Assets: Theory of Investment Decision-Making

Called “gearing” in England.

A fuller theoretical discussion of the optimum financial structure may be found in E. Schwartz, “Theory of the Capital Structure of the Firm,” Journal of Finance, March 1959. The arithmetical example follows the general pattern of Graham and Dodd, Security Analysis, McGraw-Hill, 1951, Chapter 37.

E. Schwartz, Op. Cit., Journal of Finance, March, 1959.

Financial risk was divided into borrower’s risk and lender’s risk by Keynes in The General Theory, pp. 144–145.

Franco Modigliani and Merton H. Miller, “The Cost of Capital, Corporation Finance and the Theory of Investment,” American Economic Review, June 1958.

M&M discussed their initial proposition of capital structure irrelevance in terms of a class of homogeneous firms, firms that are perfect substitutes of each other, such as firms in the same industry.

J.C. Van Horne, Financial Management & Policy, Prentice Hall, 2002, 12th edition, pp. 255–260.

Modern financial management uses the beta of a security to determine the firm’s cost of equity. The reader will see the beta estimation in Chap. 14. The estimated beta is produced by regression a security monthly returns as a function of the corresponding market returns. Because the vast majority of securities have issued long-term debt, the estimated betas involve leverage. The beta of a security rises with debt. M&M II is consistent with estimated betas and costs of equity.

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This is, of course, the concept generally used in local public finance. Since governments do not usually measure their success in terms of maximum money returns and minimum money costs, the commercial accounting that distinguishes between expenses and repayment of principal is not too important. A prime tool of municipal financial analysis is the level of debt service charges related to regular yearly revenues; this relation is some indication of the issuing area’s economic ability to carry its debt.

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Title: Debt, Equity, the Optimal Financial Structure, and the Cost of Funds
Authors: John B. Guerard Jr.
Anureet Saxena
Mustafa N. Gültekin
Publisher: Springer International Publishing
Book: Quantitative Corporate Finance
Print ISBN: 978-3-030-87268-7

Electronic ISBN: 978-3-030-87269-4

Copyright Year: 2022
DOI: https://doi.org/10.1007/978-3-030-87269-4_10

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