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Optimal capital structure and cost of debt

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Explain the relationship between the cost of capital, bond rating and capital budgeting decision-making process.

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The answer is in long essay format (approx 800 words) and discusses how the bond rating and cost of capital are related. It refers to role of classic Modigliani and Miller (MM) propositions, trade-off theory, financial distress and tax shield in the capital structuring decisions.

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Explain the relationship between the cost of capital, bond ratings and capital budgeting decision-maiking process.

In the absence of taxes the classic Modigliani and Miller (MM) propositions postulate that the value of a firm is unaffected by the capital structure decisions of the firm. Although the required rate of return on the equity increases with an increase in proportion to debt, the increase is in such a manner that weighted-average cost of capital does not change. The implications of this theory are that the choice of debt-equity mix is irrelevant and has no effect on the value of the firm. However, in reality there are so many imperfections that the capital structure of the firm does have an impact on the cost of capital of the firm. The corporate taxes have differential treatment for interest on debt and dividend payments. Whereas interest paid on debt is a deductible expense for the tax calculation purpose, dividends paid on equity do not enjoy such tax benefits.

Similarly, the financial distress of the firm has an impact on the capital structuring decisions. Financial distress is a situation when a firm is not able to meet its ...

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