Optimal Capital Structure Lecture Notes

These flashcards cover key concepts related to optimal capital structure, theories of capital structure, costs of financial distress, agency costs, and empirical evidence regarding capital structure decisions.

Optimal Capital Structure

The choice of debt and equity that maximizes the value of a firm.

Modigliani and Miller Proposition I (No Taxes)

States that the value of a leveraged firm (VL) equals the value of an unleveraged firm (VU).

Financial Distress Costs

Costs incurred when a firm has trouble meeting its contractual obligations.

Bankruptcy

A formal legal proceeding under which a company facing financial difficulty is placed under the protection of the bankruptcy court.

Agency Costs of Debt

Costs associated with the conflicts of interest between shareholders and debt holders, potentially leading to excessive risk-taking or underinvestment.

Market Timing Theory

The theory that companies issue securities that are overpriced and avoid issuing undervalued securities.

Signaling Theory

The theory suggesting that corporate financing decisions convey the manager's confidence about the firm's future prospects.

Pecking Order Theory

A theory stating that managers prefer internal financing over external financing, with a preference for debt over equity when external financing is necessary.

Tax Shield

The reduction in taxable income gained from tax-deductible expenses such as interest on debt.

Loss of Flexibility

The disadvantage faced by a company that has fully utilized its debt capacity, limiting future financing options.

WACC (Weighted Average Cost of Capital)

The average rate of return a company is expected to pay its security holders to finance its assets.