A Firm 's Total Market Value

How do free cash flows and the weighted average cost of capital interact to determine a firm’s value?

Over the years we see a steady increase in leverage ratio which means that the company makes use of more debt to finance its operations. Furthermore, a decrease in debt burden can be found because of the interest the company has to pay to its creditors which in turn leads to absorption of

The effect of financial leverage on the cost of equity is prevalent in the Modigliani-Miller capital structure theory. Since the financial leverage increases the cost of equity, it can be considered one of the disadvantages of borrowing. As shown in Appendix A, the cost of equity, at each debt to capital ratio, increases by 0.1% as the financial leverage increases by 10%. With a higher

Tax system is a legal system of imposing and collecting taxes from the citizens of the country. As it has been stated by Albert Einstein, the hardest task in the world is to understand the tax system of a country. The United States’ tax system is so complicated that its tax code contains almost 3 million words and 6,000 pages. Moreover, the taxes implied by city and state governments add more complexity to the federal taxation system. In this case, we do not need to understand the complexity of tax code system in order to get acquainted with the significant role of taxes in American society.

Generally, firms can choose among various capital structures in order to maximize overall market value of the company. It is proposed however, that

This paper addresses the solutions to Case Study 12.31 and 12.32 in the textbook authored by David Marshall, Wayne McManus, and Daniel Viele “Accounting; What the numbers mean.” Both case studies bring about a better understanding of operating and financial leverage. This discussion includes the return on investment, return on equity, contribution margin, and break-even point. All these terms associate with the two types of leverage.

The course project involved developing a great depth of knowledge in analyzing capital structure, theories behind it, and its risks and issues. Before I began this assignment, I knew nothing but a few things about capital structure from previous unit weeks; however, it was not until this course’s final project that came along with opening

Franco Modigliani and Merton Miller examined how a corporation should select securities to sell in order to attain an optimal mix between debt and equity, the mirror image of what Markowitz and Tobin had studied. Their findings led them to the conclusion that the market value of a firm is independent of its capital structure. In an efficient market, the market will place the same value on firms with equal earnings power and equal risk. Their most innovative contribution to the theory of finance was in elevating arbitrage to the level of a driving force. This Law of One Price states, “two assets with identical attributes should sell for the same price… a profitable opportunity will arise to sell the asset where it is overpriced and to buy it back when it is underpriced. The arbitrager will then lock in a sure profit, otherwise known as a free lunch.” (171) In effect, arbitragers actually fix the imperfections in the market by bidding away the

There is no universal theory of the debt-equity choice, and no reason to expect one. In this essay I will critically assess the Pecking Order Theory of capital structure with reference and comparison of publicly listed companies. The pecking order theory says that the firm will borrow, rather than issuing equity, when internal cash flow is not sufficient to fund capital expenditures. This theory explains why firms prefer internal rather than external financing which is due to adverse selection, asymmetry of information, and agency costs (Frank & Goyal, 2003). The trade-off theory comes from the pecking order theory it is an unintentional outcome of companies following the pecking-order theory. This explains that firms strive to achieve an

Capital structure is defined as the mix of the long-term sources of funds that a firm use. It is composed of equity, debt securities and affect long-term financing of the entity. It is made up by shareholder’s funds, long-term debt and preference share capital. The capital structure mostly focus on the proportions of debt and equity displayed in the company financial statements, especially in the balance sheet (Myers, 2001). The value of a firm can be calculated by the sum of the value of its firm’s debt and equity.

From this set of problems, we can see that leverage is good for the firm. Leverage has increased the value of the firm as a whole and increased the price per share. Although the cost of debt increases the firm's risk because it increases the probability of default and bankruptcy, therefore shareholders will require higher rates of return on the equity they provide, debt also provides tax savings. And we can see that in table 4, where we calculated the total value of the firm as the pure business cash flows plus the tax savings. Another reason why debt increases firm value is the fact that it reduces WACC, because the cost of debt is generally lower than the cost of equity. Another option that shareholders can do is using homemade leverage. Shareholders should pay a premium for the shares of a levered firm when the addition of debt increases value.

Already in 1958, Modigliani and Miller have pointed the discussion of capital structure towards the cost of debt and equity. According to their first proposition, in a world of no corporate taxes and with perfect markets, financial leverage has no effect on a firm’s value. In their second proposition, they state that the cost of equity equals a linear function defined by the required return on assets and the cost of debt (Modigliani and Miller, 1958).

L1 - Modigliani & Miller (1958) ‘The Cost of Capital, Corporation Finance and the Theory of Investment’

The relationship between capital structure and firm value has been discussed frequently in the literature by different researcher accordingly, in both theoretical and empirical studies. It has also been discussed that whether the firm has any optimal capital structure that has been adopted by an individual firm, or whether the proportions of debt usage is completely irrelevant to the individual firm value.

The pecking order theory ( Donaldson 1961) of capital structure is among the most influential theories of corporate leverage. The pecking order theory is based on different of information between corporate insiders and the market. According to Myers (1984), due to adverse selection, firm prefer internal to external finance. If internal finance proves insufficient, bank borrowings and corporate bonds are the preferred source of external source of finance. After exhausting both of these possibilities, the final and least preferred source of finance is