Impact of Capital Structure on Firm's Value

Financing Decision

Introduction of Debt into Capital Structure and Eventual Impact on the Shareholder Wealth

The cpaital structure is central to the organizatal sustainaiblity in the long-run. The capital structure is primarily defined by the debt ratio and it sets out how much proportion of the capital structure of the specific organization is founded by either of the debt or equity. Primarily, cpaital structure defines the nature and extent of claims over the asests of the organization. 

In accordance with the definition of the capital structure as above, shareholders and the mabnagement are faced with the question that how the composition of the capital structure should be alike. There are a number of factor that effect this and it includes the following factor. The list is not exhaustive however.

1.       Dilution of control is very important factor. The more the capital structure is composed of the debt the dilute will be the control.

2.       Cost of the either source of financie is another important factor. In relation to debt, the companyt may enjoy the taxation reliefs which are not available in the case of the equity financing.

The subject paper will assist in analysing the affect of the debt financiing on the shareholders’ swealth. The maximisation objective in relation to the shareholder’s wealth is the primary objective of the organization. The menifestation of the achivement of the objective of the maximising shareholder wealth is the rising share price which is translated into the rising firm’s or alternatively the company’s value.

How Shareholder value will be maximized?

In order to understand whether the shareholder value is maximized or not, we would observe the share price, if they have increased it would be a litmus test that shareholders wealth has increased. On the other hand, if the direction of the shareholder price is downward then it is the indicator that the shareholder wealth is decreased.

When debt would be introduced in relation to financing the operations of the company, the company will certainly enjoy tax exemptions however the corresponding increase in the interest expense will require major cash outflows which will be risky concern for the lenders and the providers of the finance. The reason is that increase in the interest expense will contain the corresponding earning per share (EPS). The conclusion is that the value of the firm that if V_f  decreased. Hence shareholder value is not maximised which is not the objective.

Comparison to Introduction of the Equity Financing and Shareholder Wealth

The rule of the decision is to make better choice of the available alternatives. The second alternative in relation to the financing is the equity financing. If the cost of the equity financing is more economical, then it would be preferable to achieve the objective of maximizing the shareholder value.

Selected Company for the Analysis

In order to understand the impact of introducing the debt to the capital structure, the increase in the shareholder is represented by the following relation:

_f =

The FCF represents the free cash flows whereas the WACC is the cost of the capital when the firm uses the combination of the equity as well as the debt financing. The lesser is the WACC the more will be the value of the firm that is the shareholder’s wealth.

In addition WACC is shown by the following relation:

WACC = W_D r_D(1-T) + w_e r_e

The above relation shows that WACC depends upon many factor such as the Weight of debt or weigh of capital in the net capital structure figure and likewise the cost of debt and the cost of equity. The more the cost is the more would be the WACC. The introduction of the debt is certainly going to increase the WACC and therefore going to decrease the value of the firm that is the shareholder’s wealth however the less the shareholder’s wealth is decreased, the more it is relatively worth in the eyes of the shareholder.

For Our Caluclation we have selected the Newco a propsed company that is looking to finance its operations throught financing of debt. Newco is undergoing the difficulties in relation to the Global Financial Structure owing to the threshold existing in relation to the level of debt. The following table shows the various levels that is threshold of the debt in relation to corresponding points of capital structure composition followed by the cost of debt in each case and the net earnings of the firm. You can easily observe that the cost of debt is increasing with the quantum of the debt. Earning per share at each level of the capital structure is increasing however the value additon is not the same in each case and hence the value of the firm is different in each case.

Assumptions while making the analysis

In relation to the anlysis we have make certain assumptions, which need to be fulfilled to understand the correlation of the debt financing to the shareholder value. The assumed tax rate for the company is 40%. Risk free rate is locked at the level of 4% whereas the market rate is the threshold of the 14%. Company has the policy of nothing to be retained in the name of undistributed reserves and whatever is earned is paid out as dividend.

Computation of the WACC

In relation to each of the proposed capital structure we will compute the rate of WACC as it is the ultimate factor that will assist us in valuing the firm. When the whole of the capital structure is equity based, the cost of equity is given by the following relation that is cost of equity = 4% + 1.2(14%-4%) turning out to be 16%. However, cost of debt is

Underlying Cause of the Problem

Management’s Plan to Overcome the Difficulty

Loss of shareholder if he is not related party

Goals align will not go

Dividend share price increase and it they are not competitor

Out of reach of shareholders