CORPORATE FINANCE ASSIGNMENT

SUBMITTED TO : PROF.SONIA VERMA

SUBMITTED BY : SUBHAM CHAKRABORTY
ERP ID :0191PGM002
PGDM SAP

1. Analyze the case and identify the model used in the case and other important
aspects covered.
The theory used in the case is based on Modigliani Miller Approach, known as the Agency
theory.
The Modigliani and Miller approach to capital theory, devised in the 1950s, advocates the capital
structure irrelevancy theory. This suggests that the valuation of a firm is irrelevant to the capital
structure of a company. Whether a firm is highly leveraged or has a lower debt component has
no bearing on its market value. Rather, the market value of a firm is solely dependent on the
operating profits of the company.

The capital structure of a company is the way a company finances its assets. A company can
finance its operations by either equity or different combinations of debt and equity. The capital
structure of a company can have a majority of the debt component or a majority of equity, or an
even mix of both debt and equity. Each approach has its own set of advantages and
disadvantages. There are various capital structure theories that attempt to establish a relationship
between the financial leverage of a company (the proportion of debt in the company’s capital
structure) with its market value. One such approach is the Modigliani and Miller Approach.

Accordingly, to the agency theory, the optimal financial structure of the capital results from a
compromise between various funding options (own funds or loans) that allow the reconciliation
of conflicts of interests between the capital suppliers (shareholders and creditors) and managers.
The study of capital structure has increasingly gained importance in strategic management
research. Paradigms derived from organizational economics have also gained popularity in
explaining firm actions. Agency theory and transaction cost economics represent two such
paradigms that rely on the notion of market imperfections. Notwithstanding the similarities
between them, these two offer different explanations of the role of debt and equity in a firm. The
governance abilities of the financing structures and the nature of assets of the firm provide two
key sources of differences. Viewing capital structure from transaction cost economics gives rise
to predictions that are contradictory to those presented by agency theory. It is argued that the
extant evidence mainly supports the transaction cost viewpoint. Two organizational phenomena-
leveraged buyouts and product diversification-are used to highlight the comparison.

2. Analyze how limitations of approach affect the capital structure

The optimal capital structure of a firm is the best mix of debt and equity financing that
maximizes a company’s market value while minimizing its cost of capital. In theory, debt
financing offers the lowest cost of capital due to its tax deductibility. However, too much
debt increases the financial risk to shareholders and the return on equity that they require.
Thus, companies have to find the optimal point at which the marginal benefit of debt equals
the marginal cost.
Limitations of Optimal Capital Structure
Unfortunately, there is no magic ratio of debt to equity to use as guidance to achieve real-world
optimal capital structure. What defines a healthy blend of debt and equity varies according to the
industries involved, line of business, and a firm's stage of development, and can also vary over
time due to external changes in interest rates and regulatory environment.
However, because investors are better off putting their money into companies with strong
balance sheets, it makes sense that the optimal balance generally should reflect lower levels of
debt and higher levels of equity.