Financial Economics

5

FIRM FINANCING DECISIONS IN A PERFECT CAPITAL MARKET

Afirm's managers invest in new plant and equipment to generate additional revenues and income. Earnings generated by the firm belong to the owners and can either be paid to them or retained within the firm. The portion of earnings paid to the firm's owners is referred to as dividends; the portion retained within the firm is referred to as retained earnings. The owners’ investment in the company is referred to as owners’ equity or, simply, equity.

If earnings are plowed back into the company, the owners expect it to be invested in projects that will enhance the firm's value, and hence, the value of the owners’ equity. Consequently, one way to pay for new investments is to use some of the previously retained earnings. But earnings may not be sufficient to support all profitable investment opportunities, and if so, management must either forego the investment opportunities or raise additional capital. New capital can be raised by borrowing, by selling additional ownership interests, or both. Borrowing can be in the form of bank loans or the issuance of debt obligations such as bonds. When we discuss additional ownership interests, we will usually assume that additional ordinary shares of common stock are issued.¹

Decisions about how the firm should be financed, whether with debt or equity, are referred to as capital structure decisions. In this chapter, we explain both the basic issues associated with capital structure decisions ...