Capital Structure Some Managerial Recommendations

The static model that we have described is not capable of identifying a precise optimal capital structure, but it does point out two of the more relevant factors: taxes and financial distress. We can draw some limited conclusions concerning these.

Taxes First of all, the tax benefit from leverage is obviously only important to firms that are in a tax-paying position. Firms with substantial accumulated losses will get little value from the interest tax shield. Furthermore, firms that have substantial tax shields from other sources, such as depreciation, will get less benefit from leverage.

Also, not all firms have the same tax rate. The higher the tax rate, the greater the incentive to borrow.

Financial Distress Firms with a greater risk of experiencing financial distress will borrow less than firms with a lower risk of financial distress. For example, all other things being equal, the greater the volatility in EBIT, the less a firm should borrow.

In addition, financial distress is more costly for some firms than others. The costs of financial distress depend primarily on the firm's assets. In particular, financial distress costs will be determined by how easily ownership of those assets can be transferred.

For example, a firm with mostly tangible assets that can be sold without great loss in value will have an incentive to borrow more. For firms that rely heavily on intangibles, such as employee talent or growth opportunities, debt will be less attractive because these assets effectively cannot be sold.

© The McGraw-Hill Companies, 2002

Ross et al.: Fundamentals of Corporate Finance, Sixth Edition, Alternate Edition

VI. Cost of Capital and Long-Term Financial Policy

17. Financial Leverage and Capital Structure Policy

© The McGraw-Hill Companies, 2002

CHAPTER 17 Financial Leverage and Capital Structure Policy

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