Introduction to Finance

Figure 18.2
, the mid-1970s, exceeding 35 percent only for limited 
occasions. But the relative use of debt rose until 1989, peaking at a nearly 45 percent of GDP. 
Many fi rms restructured themselves fi nancially during the 1980s. Some did so in attempts 
to lower their cost of capital by taking advantage of the tax deductibility of interest through 
issuing debt to repurchase common stock, thereby increasing their debt to equity ratios. Other 
fi rms went private in the 1980s, fought off takeovers, or acquired other fi rms, fi nancing the 
transactions with large amounts of debt. The surge in bankruptcies at the beginning of the 
1990s shows the folly of such excessive use of debt.
Current
Assets
Current
Liabilities
Long-term
Debt
Equity
Fixed
Assets
The Firm’s
Capital Structure
FIGURE 18.1
 The Balance 
Sheet
TA B L E 1 8 . 1
Capital Structure Options
Capital 
Structure 1
Capital 
Structure 2
Capital 
Structure 3
Debt 25.0% 
40.0%
70.0%
Equity 75.0% 
60.0%
30.0%
Weighted average
cost of capital
10.0%
8.0%
12.5%
Firm value under
Capital Structure 1: $20 million/0.10 = $200 million
Capital Structure 2: $20 million/0.08 = $250 million
Capital Structure 3: $20 million/0.125 = $160 million

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568
C H A PT E R 1 8 Capital Structure and The Cost of Capital
Into the early 1990s, the ratio of debt to economic activity fell as fi rms issued equity 
to strengthen their balance sheets and to reduce the probability of fi nancial distress due to 
over-borrowing. But as the economy grew in the 1990s, so did the relative use of debt, until 
the economic slowdown in the early part of the new millennium started to reduce debt levels. 
From 2001 through the present, we have seen the same cycle—a recessionary economy causing 
fi rms to shed debt, only for the corporate economy to borrow again as the economy grew 
through 2008. Use of debt fell during the Great Recession, but it rose again through 2015 as 
the economy began to recover.
Cashing in on Low Interest Rates 
CRISIS
The Federal Reserve System has pursued an active monetary policy to lower interest 
rates since the beginning of the 2007–2009 Great Recession. It did so through a number of 
“quantitative easing” events in which it purchased securities in an attempt to raise bond prices 
and lower interest rates. Overall, the attempt to lower interest rates has been successful through 
2016. Ten-year Treasury bonds that yielded over 5 percent in 2007 yielded as low as 1.5 per-
cent in 2012. After rising in 2013 to slightly over 3 percent, rates again dropped to well below 
2 percent in 2016. Interest rates on 30-year Treasury bonds had similar declines, with yields 
falling from over 5 percent in 2007 to below 3 percent in 2012, and remaining there into 2016.
1
The low interest rate environment was great news for borrowers. Home mortgage rates, 
which were nearly 7 percent in 2007, fell to 3.3 percent in 2012 and remained under 4 percent 
into 2016. Corporations noticed the trend in falling interest rates, too. Baa-rated corporate 
bond yields fell from over 9 percent in 2008 to around 4.5 percent in 2012 before rising to the 
lower 5 percent range in 2016. Corporate treasurers took advantage of this “cheap money” and 
increased their borrowing. Issuances of 30-year corporate bonds hit nearly 20-year highs and 
0%
1951-10-01
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5%
10%
15%
20%
25%
30%
35%
45%
40%
50%
Corporate Debt as a Percentage of GDP