Category Archives: CAPITAL STRUCTURE COST OF CAPITAL AND VALUATION

REFERENCES 1. Durand, D. The cost of debt and equity funds for business, Solomon, E (Ed.), Management of Corporate Capital. The Free Press, New York, 1959, pp. 91·116. Finance-Assignments.comInstructions Feel free to send us an inquiry, we reply back real quick. Or directly email us at order@finance-assignments.comName *Email *Phone *Requirements/ Instructions File Upload File Upload File Upload  

SUMMARY > Capital structure refers to the mix or proportion of different sources of finance (debt and equity) to total capitalization. A firm should select such a financing-mix which maximizes its value the shareholders wealth (or minimizes its overall cost of capital) such a capital structure is referred to as the optimum capital structure. > Capital structure theories explain the theoretical relations

TABLE Leverage, Capitalisation/Rates and Valuation Decreased Valuation and Increased Overall Cost of Capital Table as well as Fig reveal that with an increase in leverage (N) from zero to 0.27, the market value of the firm increases (from Rs 1,000 to Rs 1.111) and the overall cost of capital declines from 10 to 9 per cent (Phase 1). With further increases in leverage from 0.27 up to 0.54, there is no change eit

Decreased Valuation and Increased Overall Cost of Capital Beyond a certain critical point, further increases in debt proportions are not considered desirable. They increase financial risks so much that both ki and ke start rising rapidly causing (k) to rise and (V) to fall. In the effect of an increase in B S ratio from 1.08 to 6.67  from 1·405 per cent and to decrease (V) from Rs 2,88,210 to Rs 2.75.000. A

Constant Valuation and Constant Overall Cost of Capital After a certain degree of leverage is reached further moderate increases in leverage have no effect on total market value. During the middle range, the changes brought in equity-capitalization rate and debt-capitalization rate balance each other. As a result, the values of (V) and (k) remain almost constant. Finance-Assignments.comInstructions Feel free

Increased Valuation and Decreased Overall Cost of Capital During the first phase, increasing leverage increases the total valuation of the firm and low overall cost of capital. As the proportion of debt in the capital structure increases the equity (k) begins to rise as a reflection of the increased financial risk. But it is not me enough to off set the advantage of using the cheaper source of capital. Likewise,

TABLE Total Value and Cost of Capital (Traditional Approach) TRADITIONAL APPROACH It is clear that the optimal debt-equity ratio must be less than 2.67 since at this ratio, the value of the firm is Rs 2,75,000, while at a debt-equity ratio of 1.08 it is Rs,2,88,235. The traditional Approach suggests that: Other things being equal, the market value of a company’s securities will rise as the amount of levera

TRADITIONAL APPROACH The preceding discussions clearly show that the Net Income Approach (N) as well as Net Operating Income Approach (NOI) represent two extremes as regards the theoretical relationship between financing decisions as determined by the capital structure, the weighted average cost of capital and total value of me firm. While the MM Approach takes the position mat the use of debt, in the cap stru

TABLE Effect of Leverage on Shareholders Corporate Taxes The total income to both debt holders and equity holders of levered Company L is higher. The reason is that while debt-holders receive interest without tax-deduction at the corporate level, equity-holders of Company L have their incomes after tax-deduction. As a result, total income to both types of investors increases by the interest payment times the rat

Corporate Taxes As already mentioned, MM agree that the value of the firm will increase and cost of capital will decline with leverage, if corporate taxes are introduced in the exercise. Since interest on debt is tax-deductible, the effective cost of borrowing is less than the contractual rate of interest. Debt, thus, provides a benefit to the firm because of the interest payments. Therefore, a levered firm w