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Chapter 14
Capital Structure Decisions
Copyright 2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder 14–1
Prepared by Dr Buly Cardak
Learning Objectives
• Outline empirical evidence from recent studies on capital structure.
• Assess the implications of the evidence for the trade-off, pecking order and free cash flow theories.
• Explain how financing can be viewed as a marketing problem.
• Outline the main factors that financial managers should consider when determining a company’s financing strategy.
Copyright 2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder 14–2
Prepared by Dr Buly Cardak
Introduction
• MM analysis is useful in showing that if capital structure is important, the reasons must relate to factors that MM excluded by their assumptions.
• Four main theories of capital structure:
– MM leverage irrelevance — company value depends on investment rather than financing decisions.
– Trade-off theory — emphasises tax benefits of debt.
– Pecking order theory — information on projects is asymmetric and internal finance is highest in pecking order.
– Free cash flow theory — emphasises agency costs with the discipline of debt reducing unprofitable investment.
Copyright 2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder 14–3
Prepared by Dr Buly Cardak
Company Financing: Some Initial Facts
• In the US, most investment by non-financial companies is financed from internal cash flows, followed by external debt finance and then by equity.
• The pattern in Australia is similar, with over 50% of finance coming from internal equity over 2000–2004.
• High-growth companies have investment needs that exceed cash flow and, as a result, these high-growth companies depend heavily on share issues (equity finance).
Copyright 2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder 14–4
Prepared by Dr Buly Cardak
Company Financing: Some Initial Facts (cont.)
• Relationships between industry characteristics and capital structure have been reported in several studies.
– Paper, steel and airline companies typically have high leverage.
– Pharmaceutical and electronics companies typically have low leverage.
• These observations suggest that capital structure decisions are important.
Copyright 2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder 14–5
Prepared by Dr Buly Cardak
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