Lessons in Corporate Finance, 2nd Edition

CHAPTER 6An Introduction to Capital Structure Theory

We started this book by stating that our approach to corporate finance would be from the CFO's point of view. We also stated that the three main tasks of the CFO are:

1. Valuation: How to distinguish a good investment from a bad investment.
2. Financing: How to finance the investment projects a firm chooses to undertake.
3. Cash management: How to make sure the firm does not run out of cash while doing the first two tasks.

This chapter is all about task number two: financing. A firm's investment decisions dictate its funding needs. For the purposes of this unit, we will take the firm's investment decisions as given. If we know the firm's investment decisions, we can use the tools from our prior section on cash management to forecast the firm's funding needs. This is huge. If we know what projects the firm wants to undertake, we can then determine how much funding the firm needs.

Now, if a firm knows what its funding needs are, what is the best source of funds? Should it be from internal cash flows, should it be from debt, should it be from external equity, should it be from convertibles, and so forth? Once a firm decides on the sources of funds it will use, it still has many different options. Should internal cash flow funding come from excess cash or by cutting dividends? Should debt financing be obtained from banks or from issuing bonds in the capital markets? Should equity be raised from venture capital firms or from the capital ...