Excerpt

## Contents

**Introduction**

**Cost of Capital and Firm Value**

**Financial Leverage and EPS**

**Capital Structure Theories**

**Market Imperfections**

**Conclusion**

**References**

## Introduction

In accordance with the Signalling model by Ross (1977) an increase in gearing represents, in term of a company’s prospective cash flows, a positive signal to external investors. Because, due to the higher risk of financial distress, companies with less optimistic market prospective tend to avoid additional financial obligations.

This implies that an increasing indebtedness means a higher quality of business and therefore better valuation. This leads, in turn, to the assumption that the corporate management can influence a firm’s value by changing its capital structure.

If capital structure can affect value, how can firms identify an optimal capital structure and what will it look like? It is that mix of debt and equity that maximises the value of a firm and, at the same time, minimise overall cost of capital.

In their seminal article, published in 1958 and 1963, Modigliani and Miller argue that under certain assumptions the value of a firm is independent of its capital structure, but with tax-deductible interest payments, they are positively related.

Moreover, there are other approaches with partly contradictory perceptions. For instance, Myers (1998, cited in Fairchild 2003, p.6) argues that there is no universal optimal mix of debt and equity; in fact it depends on firms or industries, and therefore should be considered on a case-by-case basis. Other researchers have added market imperfections, such as bankruptcy costs, agency costs, and gains from leverage-induced tax shields to the analysis and have maintained that an optimal capital structure may exist (Hatfield *et al.* 1994, p.1).

First, this paper shows the basic determinants of a firm’s value in association with the impact of financial leverage on payoffs to stockholders. Secondly, it considers some arguments of capital structure theories, particularly the Modigliani and Miller theorem and the Traditional approach and contrasts them.

Finally, the underlying factors of the model assumptions are examined and shown that they are important in the choice of a firm’s debt-equity ratio.

## Cost of Capital and Firm Value

A company’s capital structure is conditioned by the proportion of its borrowings to equity, the debt-equity ratio, resulting from prior financing decisions. This refers to the right hand side of the balance sheet which reflects the left hand side, and thus the assets resulting from prior investment decisions. In order to examine how a firm’s value is affected by changing the amount of leverage, only capital restructurings are considered while the left hand side remains constant.

The choice between debt and equity aims to find the right capital structure that will maximise stockholder wealth. Shareholders’ required rate of return can be calculated by using equity beta, derived from the capital asset pricing model (CAPM). For an all-equity firm this rate also represents the cost of capital for its assets (Brealey *et al*. 2001, p.322). With a mixed capital structure the overall cost of capital is measured by the weighted average of both the rates on debt and on equity (WACC). In order to define a firm’s value by discounting future cash flows, the WACC is an appropriate rate. Since this discount rate and the firm’s value is negatively correlated, minimising WACC will maximise value, and thus stockholder wealth. Therefore, a certain debt-equity ratio which results in the lowest possible WACC appears to be the optimal capital structure for a firm (Ross *et al.* 1999, p.344).

## Financial Leverage and EPS

Another approach to determining the right mix of capital is to measure the impact of its change on the rate of return on equity or earnings per share (EPS).

The intensity of the leverage effect depends on the rate on debt compared to the rate on equity before restructuring. If the interest rate is below the rate on equity, the rate of return on equity will increase after increasing leverage, and vice versa.

**[...]**

- Quote paper
- Ulrike Messbacher (Author), 2004, Does capital structure influence firms value?, Munich, GRIN Verlag, https://www.grin.com/document/48170

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