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Topic 3: Capital Structure

1
Capital Structure
In our previous lecture, we have calculated the
before and after tax cost of the firms long term
contracted sources of funds.
We then combined these component costs in the
WACC to get the complete picture of the cost of
these contracted sources of funds for the firm.
The weighting of each source of funds is
determined by the firms capital structure.

Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 7, Australia: Wiley
2
Capital Structure
Capital structure is the mix of contracted debt and
equity used by a firm.
Where financial structure includes long and short
term funds, the capital structure excludes short-
term funding (maturities less than one year).
The existing capital structure of a firm is a
function of the past debt and equity raising
activities.
As retained earnings are included in the firms
capital structure, capital structure is also affected
by profitability and dividend decisions.
Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 7, Australia: Wiley
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Capital Structure
We are going to look at how changes in capital
structure affect the value of the firm, all else equal
Capital restructuring involves changing the
amount of leverage a firm has without changing
the firms assets
Increase leverage by issuing debt and
repurchasing outstanding shares
Decrease leverage by issuing new shares and
retiring outstanding debt

Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 7, Australia: Wiley
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Capital Structure
Financial leverage is the use of debt in a firms
capital structure to increase returns to equity and
is measured by debt to equity ratio.
The ratio measures the proportion of debt relative
to the amount of equity in the firm's capital
structure.
A debt to equity ratio of 0.5:1 tells us that the firm
uses twice as much equity as debt in its capital
structure ($10 of debt for each $20 of equity).

Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 7, Australia: Wiley
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Capital Structure
If a firm is financed solely by equity, the returns
generated by the firm are distributed
proportionately to the owners.
If a profitable firm is financed with debt and
equity, we would expect that the equity holders
would receive relatively higher return than the
debt holders.

Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 7, Australia: Wiley
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Capital Structure
This implies that the more debt used by the firm,
the higher the returns to shareholders will be.
So if more debt in capital structure means
more returns to shareholders, why dont firms
normally have more debt than equity in their
capital structures.
More financial leverage creates higher financial
risk. (Financial risk is the risk involved in using
debt as a source of finance).

Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 7, Australia: Wiley
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Capital Structure
While the firm is not contractually bound to pay
dividend to ordinary shareholders in a period of
lower than expected operating cash flows, the
obligation to the holders of debt securities
(including some preference shares) remains.
A firm in this situation will face financial distress
(when a firms financial obligations can not be met
or can be met only with major difficulty).

Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 7, Australia: Wiley
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Capital Structure
Clearly, shareholders will not be attracted to a firm
with a high probability of financial distress. While the
shareholders return would be higher in good times,
slight downturn in operations could lead the company
being liquidated and the shareholders could then lose
their entire investment.

As such, no financial leverage would normally be


associated with lower returns to shareholders and too
much financial leverage would normally be associated
with financial distress.

Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 7, Australia: Wiley
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Business Risk
Factors that affect business risk:
Demand variability
Sales price variability
Input cost variability
Ability to develop new products
Foreign exchange exposure
Operating leverage (fixed vs variable costs)

Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 7, Australia: Wiley
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Advantages of Debt
Interest is tax deductible (lowers the effective cost
of debt)
Debt-holders are limited to a fixed return so
stockholders do not have to share profits if the
business does exceptionally well
Debt holders do not have voting rights- how it is
an advantage
Disadvantages of Debt
Higher debt ratios lead to greater risk and higher
required interest rates (to compensate for the
additional risk)
Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 7, Australia: Wiley
11
Debt Financing and Agency Costs
One agency problem is that managers can use
corporate funds for non-value maximizing
purposes.

A second agency problem is the potential for


underinvestment.
Debt increases risk of financial distress.
Therefore, managers may avoid risky projects
even if they have positive NPVs.

Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 7, Australia: Wiley
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Choosing a Capital Structure
Primary goal of financial managers - Maximise
shareholder wealth therefore,We want to choose the
capital structure that will maximize shareholder
wealth.
The optimal capital structure is the mix of
contracted debt and equity that maximizes the value
of the firm.
The optimal capital structure would include the
right proportion of debt to minimize WACC without
decreasing the value of the firm.
Maintaining the value of the firm with the lowest
possible WACC is consistent with maximising
shareholder value
Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 7, Australia: Wiley
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Factors Determining Capital Structure
Trading on Equity- The word equity denotes the
ownership of the company. Trading on equity means taking
advantage of equity share capital to borrowed funds on
reasonable basis. Trading on equity becomes more
important when expectations of shareholders are high.

Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 7, Australia: Wiley
14
Factors Determining Capital Structure
Degree of control- In a company, it is the directors
who are so called elected representatives of equity
shareholders. These members have got maximum
voting rights in a concern as compared to the
preference shareholders and debenture holders.
Preference shareholders have reasonably less voting
rights while debenture holders have no voting rights. If
the companys management policies are such that
they want to retain their voting rights in their
hands, the capital structure consists of debenture
holders and loans rather than equity shares.

Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 7, Australia: Wiley
15
Factors Determining Capital Structure
Flexibility of financial plan- In an enterprise,
the capital structure should be such that there is
both contractions as well as relaxation in plans.
Debentures and loans can be refunded back as the
time requires. While equity capital cannot be
refunded at any point which provides rigidity to
plans. Therefore, in order to make the capital
structure possible, the company should go for
issue of debentures and other loans.

Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 7, Australia: Wiley
16
Factors Determining Capital Structure
Choice of investors- The companys policy
generally is to have different categories of investors
for securities. Therefore, a capital structure should
give enough choice to all kind of investors to
invest.

Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 7, Australia: Wiley
17
Factors Determining Capital Structure
Capital market condition- In the lifetime of the
company, the market price of the shares has got an
important influence. During the depression
period, the companys capital structure generally
consists of debentures and loans. While in period
of booms and inflation, the companys capital
should consist of share capital generally equity
shares.

Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 7, Australia: Wiley
18
Factors Determining Capital Structure
Period of financing- When company wants to
raise finance for short period, it goes for loans from
banks and other institutions; while for long period
it goes for issue of shares and debentures

Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 7, Australia: Wiley
19
Factors Determining Capital Structure
Cost of financing- In a capital structure, the
company has to look to the factor of cost when
securities are raised. It is seen that debentures at
the time of profit earning of company prove to be a
cheaper source of finance as compared to equity
shares where equity shareholders demand an extra
share in profits.

Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 7, Australia: Wiley
20
Factors Determining Capital Structure
Stability of sales- An established business which has
a growing market and high sales turnover, the
company is in position to meet fixed commitments.
Interest on debentures has to be paid regardless of
profit. Therefore, when sales are high, thereby the
profits are high and company is in better position to
meet such fixed commitments like interest on
debentures and dividends on preference shares. If
company is having unstable sales, then the company is
not in position to meet fixed obligations. So, equity
capital proves to be safe in such cases.

Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 7, Australia: Wiley
21
Factors Determining Capital Structure
Sizes of a company- Small size business firms
capital structure generally consists of loans from
banks and retained profits. While on the other
hand, big companies having goodwill, stability and
an established profit can easily go for issuance of
shares and debentures as well as loans and
borrowings from financial institutions. The
bigger the size, the wider is total
capitalization.

Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 7, Australia: Wiley
22
Evaluating Changes in Capital Structure
Earnings per share (EPS) dilution is also an
important factor in assessing a new share issue as
a source of funds
EPS is the total earnings of the firm divided by the
number of shares on issue.
If earnings are expected to remain at a constant
level, issuing new shares will reduce the amount
of EPS.
This reduction in EPS is called dilution (the
decrease in the proportion of income each share is
entitled to).
Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 7, Australia: Wiley
23
Evaluating Changes in Capital Structure
Example
Lummox Ltd has 2 million shares trading at $1 each
on the SPSE. The company has no debt. Earnings
last year were $500 000. Lummox wants to purchase
a property for an investment project that will begin
generating cash inflows 1 year from now. The
property costs $1 million and new shares can be sold
at $1 each. (Transaction cost is ignored). What is the
impact of the new share issue on EPS?

Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 7, Australia: Wiley
24
Evaluating Changes in Capital Structure
Example
Current EPS = earnings/number of ordinary shares
EPS = 500 000 / 2 000 000
= 0.25 or 25 cents per share

New EPS = 500 000 / 3 000 000


= 0.1667 or 17 cents per share

Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 7, Australia: Wiley
25
Evaluating Changes in Capital Structure
Example contd
Thus current investors in Lummox will find that EPS has
fallen from 25 cents to 17 cents. This is really attributable to
the ownership interest of the shareholder being diluted. If a
shareholder does not participate in the new share issue, their
proportional ownership of the firm will fall and they will be
entitled to a smaller share of the earnings. If a shareholder
currently owns 10% of the shares on issue and purchases 10%
of the new shares that will be issued, they will be entitled to
the same proportion of earnings on their ownership stake.

Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 7, Australia: Wiley
26
EBIT-EPS analysis
Investors are interested in the firms past and future EPS
amounts.
It makes sense to evaluate the impact of a capital structure
change on EPS, given that the market is so interested in
this particular figure.
EBIT-EPS analysis relates earnings before interest and tax
to the after-tax income entitlement of each ordinary share.

The indifference point is the level of EBIT that generates


the same EPS for all financing alternatives under
consideration.

Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 7, Australia: Wiley
27
EPS and Capital structure change
Example
The board of Multimax is considering issuing new equity
to repay all of the units of the firms debt. The company
currently has 5 million shares on issue trading at $2 and
could issue new shares for this amount (ignore
floatation costs). Debt is currently $600 000 and interest
charges are 10% per annum. The company is owned by
investors who are unable to benefit from dividend
franking and it generates an annual EBIT of $2 000 000.
What would happen to Multimaxs EPS if the new equity
issue and debt repayment went ahead?

Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 7, Australia: Wiley
28
EPS and Capital structure change
Current capital Proposed capital
structure structure
Debt at 10% interest 600 000 0
Ordinary shares 10 000 000 10 600 000
Total debt and equity 10 600 000 10 600 000
Number of ordinary shares issued 5 000 000 5 300 000
EBIT 2 000 000 2 000 000
Less interest expense 60 000 0
Earnings before tax (EBT) 1 940 000 2 000 000
Less tax at 30% 582 000 600 000
Net income available to ordinary shares 1 358 000 1 400 000

EPS 0.2716 0.2642

Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 7, Australia: Wiley
29
EPS and Capital structure change
Example contd
Note that the total amount of funds used by the firm is
unchanged because we are looking at restructure
rather than raising additional funds.
The EPS for the proposed capital structure is 26 cents.
A decrease of 1 cent per share from current capital
structure,
There is a decreased risk of firm with the new capital
structure. By repaying the debt, Multimax has
eliminated the financial risk of the firm and the
shareholders will now be faced only with business risk.
Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 7, Australia: Wiley
30
EBIT-EPS analysis and Choice of Capital structure
Example
Lummox Ltd has 2 million shares trading at $1 each on
the SPSE. The company has no debt. Earnings last year
were $500 000 and the current projects of the firm are
expected to continue this level of earnings indefinitely .
Lummox wants raise $1 million for a new project that is
expected to increase EBIT by $300 000 per annum for
the foreseeable future. The company can issue new
ordinary shares at net $1 per share. Alternatively, the
funds can be raised by issuing bonds with an annual
coupon of 10%. Show the impact of the financing choice
on Lummoxs EPS.
Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 7, Australia: Wiley
31
EBIT-EPS analysis and Choice of Capital structure
Capital structure

Current New New Debt


Equity
Debt at 10% interest 0 1 000 000
Ordinary shares 2 000 000 3 000 000 2 000 000
Total debt and equity 2 000 000 3 000 000 3 000 000
Number of ordinary shares issued 2 000 000 3 000 000 2 000 000
EBIT 500 000 8 00 000 800 000
Less interest expense 0 0 100 000
Earnings before tax (EBT) 500 000 800 000 700 000
Less tax at 30% 150 000 240 000 210 000
Net income available to ordinary 350 000 560 000 490 000
shares
EPS 0.1750 0.1867 0.2450
Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 7, Australia: Wiley
32
EBIT-EPS analysis and Choice of Capital structure
Example contd
EPS rises from 18 cents to 19 cents if Lummox uses
equity to finance the new project. Using equity
means there is no interest tax shield from debt, so
the increase is attributable to the relatively higher
EBIT that is generated by the new project compared
to the existing projects of the firm. The gain from
leverage is a further 6 cents per share (that is 25 19)
if Lummox chooses debt finance. Though, EPS is
higher, it is achieved by taking on financial risk.

Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 7, Australia: Wiley
33
EBIT-EPS analysis with existing debt and preference shares

Existing debt and preference shares should be


taken into consideration when doing an EBIT-EPS
analysis.

Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 7, Australia: Wiley
34
EBIT-EPS analysis with existing debt and preference shares

Example
Swimmingly Ltd operates aquatic fun centres in a
number of cities. The company has decided to build
another centre that is expected to generate a permanent
increase in EBIT of $1oo ooo per annum. Current EBIT is
$350 000. Swimmingly currently has a capital structure
that utilizes bonds, ordinary equity and preference
shares. The $200 000 of issued bonds pay 8% per
annum. Preference shares pay an annual fixed dividend
of $150 000. 250 000 ordinary shares have been issued
and are trading at $2 per share.
Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 7, Australia: Wiley
35
EBIT-EPS analysis with existing debt and preference shares

Example contd
Swimmingly needs to raise $500 000 to construct the
new aquatic centre. Assuming the company can issue
new shares at the current market price. What is the
impact on EPS if new shares are issued to fund the
centre?
If new debt can be raised at 10% interest rate, what is the
impact on EPS of using debt rather than a new equity
issue?

Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 7, Australia: Wiley
36
EBIT-EPS analysis with existing debt and preference shares
Capital structure
Current New Equity New Debt
Debt at 10% interest 500 000
Debt at 8% interest 200 000 200 000 200 000
Ordinary shares 500 000 1 000 000 500 000

Total debt and equity 700 000 1 200 000 1 200 000
Number of new shares issued 250 000
Total Number of ordinary shares issued 250 000 500 000 250 000
EBIT 350 000 450 000 450 000
Less interest expense 16 000 16 000 66 000
Earnings before tax (EBT) 334 000 434 000 384 000
Less tax at 30% 100 200 130 200 115 200
Net income (NI) 233 800 303 800 268 800
Less Preference dividend 150 000 150 000 150 000

Beal D.,NI available


Goyen M. andto ordinaryA.
Shamsuddin shareholders 83 Finance,2nd
(2008). Introducing Corporate 800 153 chapter
ed., 800 7, Australia:
118 800 Wiley
37
EBIT-EPS analysis with existing debt and preference shares

Example contd
Preference share dividends are not tax deductible, so
they reduce the amount of after-tax net income that is
available for distribution to ordinary shareholders.

Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 7, Australia: Wiley
38
EPS indifference point
The indifference point is the level of EBIT that generates
the same EPS for all financing alternatives under
consideration.
The indifference point for EBIT-EPS analysis is found using
the following equation

Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 7, Australia: Wiley
39
EPS indifference point
The following example shows the application of previous
equation using capital structure choice faced by
Swimmingly Ltd.
EPS new equity EPS new debt
(EBIT 16 000)(1-0.3)-150 000 =EBIT 66 000)(1-0.3)-150 000
500 000 250 000
0.7EBIT 11 200 150 000 = 0.7EBIT 46 200 150 000
500 000 250 000
0.7EBIT 161 200 = 2(0.7EBIT 196 200)
2(196 200) 161 200 = 1.4EBIT 0.7EBIT
231 200 = 0.7EBIT
EBIT = 330 286

Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 7, Australia: Wiley
40
EPS indifference point
The indifference point tells us that if EBIT is
$330,286; EPS will be equal under either financing
plan. The EPS at the indifference point is 14 cents.
You can calculate this for yourself by changing the
EBIT for Swimmingly Ltd to $330 286 in either the
debt or equity fundraising proposals.

Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 7, Australia: Wiley
41
Break-Even EBIT
When considering an equity plan or a debt plan it
is important to note the following.
For EBIT lower than any given indifference
point, the equity plan will generate higher
EPS.
For EBIT higher than the indifference point,
the plan that uses debt will have the higher
EPS.
The relationship between the indifference point
and the preference for either a debt or equity plan
Bealwill always
D., Goyen hold.
M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 7, Australia: Wiley
42
Limitations of EBIT-EPS analysis
maximising EPS is not consistent with
maximising shareholder wealth.
Taken together, these limitations mean that
EBIT-EPS analysis should not be the only
consideration in the choice of capital structure.

Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 7, Australia: Wiley
43
What are signaling effects in capital structure?
Assumptions:
Managers have better information about a firms long-
run value and firms prospects than outside investors.
Managers act in the best interests of current
stockholders.
What can managers be expected to do?
Issue stock if they think stock is overvalued.
Issue debt if they think stock is undervalued.
As a result, investors view a stock offering negatively--
managers think stock is overvalued.

Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 7, Australia: Wiley
44
Financial Choices
Trade-off Theory - Theory that capital structure
is based on a trade-off between tax savings and
distress costs of debt.

Pecking Order Theory - Theory stating that


firms prefer to issue debt rather than equity if
internal finance is insufficient.

Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 7, Australia: Wiley
45
Pecking Order Theory
The announcement of a stock issue drives down
the stock price because investors believe
managers are more likely to issue when shares are
overpriced.
Therefore firms prefer internal finance since funds
can be raised without sending adverse signals.
If external finance is required, firms issue debt
first and equity as a last resort.
The most profitable firms borrow less not because
they have lower target debt ratios but because
they don't need external finance.
Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 7, Australia: Wiley
46
Pecking Order Theory
Some Implications:
Internal equity may be better than external equity.
If external capital is required, debt is better.
(There is less room for difference in opinions about
what debt is worth).

Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 7, Australia: Wiley
47
Investment Opportunity Set and Reserve
Borrowing Capacity
Firms with many investment opportunities should
maintain reserve borrowing capacity, especially if
they have problems with asymmetric information
(which would cause equity issues to be costly).

Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 7, Australia: Wiley
48
Windows of Opportunity
Managers try to time the market when issuing
securities.
They issue equity when the market is high and
after big stock price run ups.
They issue debt when the stock market is low
and when interest rates are low.

Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 7, Australia: Wiley
49
Implications for Managers
Take advantage of tax benefits by issuing debt,
especially if the firm has:
High tax rate
Stable sales
Low operating leverage

Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 7, Australia: Wiley
50
Implications for Managers
Avoid financial distress costs by maintaining
excess borrowing capacity, especially if the firm
has:
Volatile sales
High operating leverage
Many potential investment opportunities
Special purpose assets (instead of general
purpose assets that make good collateral)

Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 7, Australia: Wiley
51
Implications for Managers (Continued)
If manager has asymmetric information regarding
firms future prospects, then avoid issuing equity if
actual prospects are better than the market
perceives.
Always consider the impact of capital structure
choices on lenders and rating agencies attitudes.

Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 7, Australia: Wiley
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