Capital Structure Flashcards
Maximising Firm Value vs Maximising
Shareholder Interests
Managers should choose the capital structure that they have the highest firm value because this capital structure most beneficial to the firm’s stockholders.
If the firm issues new equity or debt, and invests the proceeds in a zero NPV project, the firm will have more real assets, and thereby grow in value. Does this mean that managers should always seek to grow the size of the firm by issuing more securities? The answer is no, because growth in this manner does not make any of the firm’s investors better off. When we say that managers should choose the capital structure that maximizes the firm’s value, we mean that managers should choose the optimal mix of debt and equity that will lead to the highest firm value, holding the firm’s real assets fixed . If the manager instead issues equity or debt to invest in more real capital projects, the firm will grow in size, but investors will not be better off unless those projects had positive NPV.
Financial Distress Costs
When a firm has debt, conflicts of interest arise between stockholders and bondholders. Because of this, stockholders are tempted to pursue selfish strategies. These conflicts of interest, which are magnified when financial distress is incurred, impose agency costs on the firm. We describe three kinds of selfish strategies that stockholders use to hurt the bondholders and help themselves. These strategies are costly because they will lower the market value of the whole firm
