Chapter 7 - Effects of Capital Structure on Cost of Capital

Abstract

This chapter reviews the capital structure literature and its implications for the cost of equity. The cost of equity increases with the risks investors have to bear, and the more debt a firm uses, the more risk its shareholders bear. This chapter first considers the effect of taxes on the cost of capital. Corporate interest expense is tax deductible leaving more of the firm's operating earnings for investors; however, personal interest income is usually taxed and leaves less of the firm's operating earnings in investors' pockets and increases required return relative to equity. This chapter also addresses the need to make timely interest payments, which helps discipline corporate managers and keeps them from using the corporation's money inefficiently. It discusses how the choice of debt versus equity conveys information about the managers' private views of the firm's prospects to outside investors. Finally the chapter looks at “double leverage,” the “gamma” parameter, special company structures (master limited partnerships and real estate investment trusts); excessive debt, and the use of actual or deemed capital structures in various jurisdictions.