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Debt and Capital Structure: Preferred Stock

Most firms are able to use 30 to 50 percent debt in their capital structure without exceeding norms acceptable to creditors and investors.

How does the firm decide on the appropriate weights for debt, preferred stock, and common stock financing.

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Factors which go in determining right mix or right weights:

The Nature of Agency Cost of Debt

The agency cost of debt is associated with monitoring, enforcing, credibly promising, and constraining decisions, and result from the general situation in which the optimization problem for one constituency is suboptimal for another constituency. In terms of the agency costs of debt, Jensen and Meckling (1976) suggest that the potential conflict between equity and debt claimants is presented primarily in terms of wealth expropriation and risk shifting.

Shareholders may capture wealth from bondholders by investing in new projects that are riskier than those presently held in the firm's portfolio. If the projects perform well, shareholders capture most of the gains, while bondholders bear most of the cost (Fama and Miller, 1972). The fact that shareholders of a corporation with outside debt have a call option on the corporate assets and can influence the underlying risk creates a moral hazard problem. Firms typically mitigate this problem by ...

Solution Summary

This solution explains how firms decide on their appropriate weight for debt, preferred stock and common stock