1. Introduction to capital structure theory Aa Aa In his private office, just down the hall from his conference room, the Chief Financial Officer (CFO) of Turner Newspaper Group (TNG) is meeting with his newly hired assistant, Richard CFO Before our next meeting with the bankers, let's take a second and make sure that we have a common understanding about the company's capital structure. TNG can potentially have three different capital structures: its current, actual capital structure, a target capital structure, and an optimal capital structure. If we wanted to talk about the long-run capital structure at which TNG ultimately wants to operate, we'd be talking about which capital structure, Richard? Richard We'd be talking about TNG's capital structure. This is the capital structure that TNG wants to operate, and it can differ from its ideal capital structure. CFO Very good. Now, if TNG's current capital structure consists of 54.5% debt and 45.5% common equity, then, Richard, how would we know if we are operating with our optimal capital structure? Richard An optimal capital structure is characterized by two important attributes: First, it the firm's weighted average cost of capital, and second, it which should make our shareholders very happy the value of the firm, CFO Again, that's great! Now, tell me, in general and without talking about TNG in particular, why would a company ever be willing to operate with a capital structure that is not equal to its desired or target capital structure? Richard Well, sir, there are several reasons that I can think of. Let's see. First, a firm may use debt and equity financing that differs from its targeted amounts if its business activities or its industry becomes more risky or firm's reliance on debt financing. Second, the availability of competitive. In general, these circumstances will decrease a may prompt a company to borrow more or issue new shares and thereby deviate from its target capital structure. Lastly, the advantage of using a less-than-optimal level of debt is that it the firm's reserve borrowing capacity CFO Richard, you've passed my first test with flying colors! With this understanding of the theory and some real-world experience, you'll be earning your bonus in no time