1. Chapter 17 Capital Structure Determination © 2001 Prentice-Hall, Inc. Fundamentals of Financial Management, 11/e Created by: Gregory A. Kuhlemeyer, Ph.D. Carroll College, Waukesha, WI

7. Capitalization Rate Capitalization Rate, k o -- The discount rate used to determine the present value of a stream of expected cash flows. k o k e k i B B + S S B + S = + What happens to k i , k e , and k o when leverage, B/S, increases?

12. Required Rate of Return on Equity Capital costs and the NOI approach in a graphical representation. 0 .25 .50 .75 1.0 1.25 1.50 1.75 2.0 Financial Leverage (B / S) .25 .20 .15 .10 .05 0 Capital Costs (%) k e = 16.25% and 17.5% respectively k i (Yield on debt) k o (Capitalization rate) k e (Required return on equity)

15. Optimal Capital Structure: Traditional Approach Traditional Approach Financial Leverage (B / S) .25 .20 .15 .10 .05 0 Capital Costs (%) k i k o k e Optimal Capital Structure

27. Required Rate of Return on Equity with Bankruptcy Financial Leverage (B / S) R f Required Rate of Return on Equity (k e ) k e with no leverage k e without bankruptcy costs k e with bankruptcy costs Premium for financial risk Premium for business risk Risk-free rate

32. Tax-Shield Benefits Tax Shield -- A tax-deductible expense. The expense protects (shields) an equivalent dollar amount of revenue from being taxed by reducing taxable income. Present value of tax-shield benefits of debt * = ( r ) ( B ) ( t c ) r = ( B ) ( t c ) * Permanent debt, so treated as a perpetuity ** Alternatively, $240 annual tax shield / .12 = $2,000, where $240=$600 Interest expense x .40 tax rate. = ( $5,000 ) ( .4 ) = $2,000 **

37. Bankruptcy Costs, Agency Costs, and Taxes Optimal Financial Leverage Taxes, bankruptcy, and agency costs combined Net tax effect Financial Leverage (B/S) Cost of Capital (%) Minimum Cost of Capital Point