Does it matter whether firms use debt or equity to finance their activities? We start the discussion of this important question in a very stylized world. We learn that, in principle, the value of a company is unrelated to its financing policy and that, ultimately, the financing policy simply defines how a given firm value is split among the various providers of capital.
We also learn, however, that financing decision change the risk characteristics of the various sources of capital, in particular the firm's equity. Because debtholders are entitled to preferred returns whereas shareholders only have a residual claim, the risk of the equity increases as leverage goes up. Shareholders require a compensation for this additional risk, which is why there is a positive relation between the firm's leverage and the expected return on equity.
These findings and discussions have imortant implications for dimensions such as the banking regulation and executive compensation. We briefly discuss these implications at the end of the section.
- View Receive a grade