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Fi 516

In: Business and Management

Submitted By xbenchandlerx
Words 462
Pages 2
The capital structure of a company depends on the effect of debt mainly concerned with WACC and FCF. Many factors are relevant to this decision. Increasing debt makes the firm more risky and more likely to end up in bankruptcy. If this happens, all the costs, direct and indirect, will cause the FCF to decrease.
The effect of debt will also create a situation where manager might be more or less likely to choose projects that are risky, and may not have a positive NPV due to the amount of FCF available.
As debt holders have the first right to cash flows, the increased risk of more debt causes the stock to increase, and thus possibly pushing some investors away.
On the other hand, Companies can use the interest expenses as tax deductions, which would reduce the amount of taxes paid, and increase the funds in which to payout to investors.
Based on this, the WACC can be variable since it is a balance, or average, between debt and equity. I think the main concern is to work this balance to your benefit. Finding the right amount of tax savings from interest as to keep the cost of equity as a good place.

Under the MM theory, they first assumed that taxes were irrelevant. This makes the capital structure of a company irrelevant since the value of the leveraged firm equals the value of the unleveraged firm.
When they included corporate taxes, the benefits leaned toward the leveraged firm as the value increased over the unleveraged firm by the amount of taxes time their debt.
MM then included personal taxes into the theory, which shows that financing with debt is still better but not as much as with only corporate taxes.
As there trade-off theory states, it is important to find the balance between costs and benefits. MM Ignores bankruptcy cost and assumes managers and investors have the same information.
This is not completely so in the real world as riskier

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