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Capital Structure and Firm Value

Prepared By: Prof. Divyesh Gandhi

Capital Structure:
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.
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.

Value of the Firm

Factors influencing to capital


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

Theories of capital Structure

Net Income Approach (NI)
Net Operating Income Approach (NOI)
Traditional Approach (TA)
Modigliani and Miller Approach (MM)

Optimal debt-equity ratio

Need to consider two kinds of risk:
Business risk
Financial risk

Business Risk
Standard measure is beta (controlling for financial risk)

Demand variability
Sales price variability
Input cost variability
Ability to develop new products
Foreign exchange exposure
Operating leverage (fixed vs variable costs)

Financial Risk
The additional risk placed on the common stockholders as a result of the
decision to finance with debt

Example of Relationship Between

Financial and Business Risk
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.

Financial Risk
Leverage increases shareholder risk
Leverage also increases the return on equity (to compensate for the higher

Advantages of Debt
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

Disadvantages of Debt
Higher debt ratios lead to greater risk and higher required interest rates (to
compensate for the additional risk)

Status of Your Symbol is a

Symbol, not a Status.