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Capitalstructureppt 130719100546 Phpapp02

The document discusses capital structure and the mix of debt and equity used to finance a firm. It defines capital structure and notes that the value of a firm is the sum of its debt and equity value. An optimal capital structure balances maximizing firm value while considering various risk and cost factors related to different levels of debt versus equity. These factors include business risk, taxes, financial flexibility, growth rates and market conditions. The document also outlines different approaches to valuing capital structure and notes how leverage increases shareholder risk but can also increase return on equity if the business performs well.

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Sunny Dogra
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14 views

Capitalstructureppt 130719100546 Phpapp02

The document discusses capital structure and the mix of debt and equity used to finance a firm. It defines capital structure and notes that the value of a firm is the sum of its debt and equity value. An optimal capital structure balances maximizing firm value while considering various risk and cost factors related to different levels of debt versus equity. These factors include business risk, taxes, financial flexibility, growth rates and market conditions. The document also outlines different approaches to valuing capital structure and notes how leverage increases shareholder risk but can also increase return on equity if the business performs well.

Uploaded by

Sunny Dogra
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PPT, PDF, TXT or read online on Scribd
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Debt versus Equity

Definition: Capital Structure is the mix of


financial securities used to finance the firm.
The value of a firm is defined to be the sum of the
value of the firms debt and the firms equity.
V=B+S
If the goal of the management of the firm is to
make the firm as valuable as possible, then the
firm should pick the debt-equity ratio that makes
the pie as big as possible.

S B Value of the Firm

2
Business Risk
Company Tax exposure
Financial Flexibility
Management Style
Growth Rate
Market Condition
Cost of Fixed Assets
Size of Business Organization
Nature of business Organization
Elasticity of Capital Structure
Net Income Approach (NI)
Net Operating Income Approach (NOI)
Traditional Approach (TA)
Modigliani and Miller Approach (MM)
Need to consider two kinds of risk:
Business risk
Financial risk
Standard measure is beta (controlling for
financial risk)
Factors:
Demand variability
Sales price variability
Input cost variability
Ability to develop new products
Foreign exchange exposure
Operating leverage (fixed vs variable costs)
The additional risk placed on the common
stockholders as a result of the decision to
finance with debt
If the same firm is now capitalized with 50%
debt and 50% equity with five people
investing in debt and five investing in equity
The 5 who put up the equity will have to
bear all the business risk, so the common
stock will be twice as risky as it would have
been had the firm been all-equity
(unlevered).
Financial leverage concentrates the firms
business risk on the shareholders because
debt-holders, who receive fixed interest
payments, bear none of the business risk.
Leverage increases shareholder risk
Leverage also increases the return on
equity (to compensate for the higher risk)
Interest is tax deductible (lowers the
effective cost of debt)
Debt-holders are limited to a fixed return
so stockholders do not have to share profits
if the business does exceptionally well
Debt holders do not have voting rights
Higher debt ratios lead to greater risk and
higher required interest rates (to
compensate for the additional risk)
Thank
you

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