Corporate Finance: Leverage & Capital Structure

This corporate finance assignment delves into the concepts of financial leverage and capital structure theories. It explores the advantages of debt financing, the assumptions behind the Modigliani-Miller proposition, and the real-world implications of these theories. The assignment also examines the impact of transaction costs, bankruptcy costs, and taxes on capital structure decisions.

Running head: CORPORATE FINANCE
Corporate Finance
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Table of Contents
Question 1: Financial leverage and theories of capital structure...............................................2
1.1 Two advantages of debt over equity funding:..................................................................2
1.2 Impact of financial leverage on shareholder returns:.......................................................2
1.3 Jensen’s free cash flow theory to depict the relationship of limited opportunity firms to
have high or low debt levels and role of debt in curbing such behaviour:.............................2
Question 2: Modigliani-Miller (MM) capital structure irrelevance propositions......................3
2.1 Three assumptions in MM approach:...............................................................................3
2.2 Reasons that such assumptions do not hold in practice:..................................................3
2.3 Impact of the reconciliation of these assumptions on investors and/or firm preference
for or against debt in capital structure:...................................................................................4
References:.................................................................................................................................5

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Question 1: Financial leverage and theories of capital structure
1.1 Two advantages of debt over equity funding:
An organisation that raises funds through debt instead of equity primarily has the
following two advantages:
 The lender does not have any control over the business. Once the loan is repaid, there
is no relationship with the financier.
 Secondly, the interest paid on the part of the organisation is tax deductible.
1.2 Impact of financial leverage on shareholder returns:
The financial leverage is utilised in magnifying the earnings of the shareholders. It is
reliant on the assumption that the fixed cost funds could be accumulated at a price lower
compared to the organisation’s rate of return on its assets (Ehrhardt & Brigham, 2016). At the
time the variation between the earnings funded by fixed asset funds and the prices of such
funds are distributed to the equity shareholders, they would receive additional earnings
without enhancement of their investments.
As a result, return on equity and earnings per share of the organisation increase.
Conversely, if the organisation obtains fixed cost funds at a greater cost compared to earnings
from such assets, there would be a fall in earnings per share and return on equity. Thus, these
two measures help in measuring the impact of financial leverage on shareholder returns.
1.3 Jensen’s free cash flow theory to depict the relationship of limited opportunity firms
to have high or low debt levels and role of debt in curbing such behaviour:
According to Jensen’s free cash flow theory, it is a method of looking at the cash flow
of an organisation to determine the amount available for distribution among the stock holders
of the organisation. In addition, Jensen posited that the organisations generating cash in

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excess of the need to finance positive NPV projects encounter greater agency problems,
which arise from the separation of control and ownership. This is because the free cash flow
exacerbates the interest conflict between the managers and the shareholders (Foley &
Manova, 2015). With the rise in payouts to the shareholders, there would be a rise in share
price. In case, additional cash is retained, the falling marginal utility of the investments would
cause the returns and stock price to fall as well.
Under such situation, the role of debt is immense in minimising the agency costs.
There is no voice of the debt holders in the business operations until renewal is needed for
debt or the organisation fails to meet the contract. It constrains the managers to adhere to the
payment terms, which help in making wise investments.
Question 2: Modigliani-Miller (MM) capital structure irrelevance propositions
2.1 Three assumptions in MM approach:
The three significant assumptions in MM approach include the following:
 There is no transaction cost for purchasing and selling securities along with no
bankruptcy cost.
 The borrowing cost is identical for both the investors and the organisations.
 There is absence of tax in the capital market (Fracassi, 2016).
2.2 Reasons that such assumptions do not hold in practice:
The following are the main reasons that the above-stated assumptions do not hold
good in practice:
 The transaction cost has impact on the arbitrage process. At the time of security
purchase, this cost is associated with commission or brokerage for which additional
amount is to be incurred. This enhances the cost price of the stock, since it needs a

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higher amount despite the identical return. Hence, higher market value would be
enjoyed on the part of the levered firm, which the unlevered firm does not.
 Since an organisation owns more assets and credit reputation in the open market
compared to an individual, the position of the former would be better than the latter
(Hillier et al., 2013). As a result, the borrowing cost of the individual would be higher
in contrast to the organisation.
 In reality, there is no existence of perfect capital markets and thus, taxes exist in the
capital market.
2.3 Impact of the reconciliation of these assumptions on investors and/or firm
preference for or against debt in capital structure:
As this approach proposes that there is no tax and bankruptcy cost, there would be no
tax benefits from the payments and hence, there would not be any change or benefit to the
weighted average cost of capital irrespective of the borrowing method of the organisation
(Vernimmen et al., 2014). Additionally, as there are no changes or benefits from rise in debt,
there is no influence of capital structure on the stock price of the organisation, which depicts
its irrelevancy to the share price. However, in reality, the organisations having higher debt
proportion are more valuable due to the interest tax shield.

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References:
Damodaran, A. (2016). Damodaran on valuation: security analysis for investment and
corporate finance (Vol. 324). John Wiley & Sons.
Ehrhardt, M. C., & Brigham, E. F. (2016). Corporate finance: A focused approach. Cengage
Learning.
Foley, C. F., & Manova, K. (2015). International trade, multinational activity, and corporate
finance. Economics, 7(1), 119-146.
Fracassi, C. (2016). Corporate finance policies and social networks. Management Science.
Hillier, D., Ross, S., Westerfield, R., Jaffe, J., & Jordan, B. (2013). Corporate finance.
McGraw Hill.
Vernimmen, P., Quiry, P., Dallocchio, M., Le Fur, Y., & Salvi, A. (2014). Corporate finance:
theory and practice. John Wiley & Sons.